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Managerial
Accounting
Fifteenth Edition
Ray H. Garrison, D.B.A., CPA
Professor Emeritus
Brigham Young University
Eric W. Noreen, Ph.D., CMA
Professor Emeritus
University of Washington
Peter C. Brewer, Ph.D., CPA
Wake Forest University
MANAGERIAL ACCOUNTING, FIFTEENTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2015 by
McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions
© 2012, 2010, and 2008. No part of this publication may be reproduced or distributed in any form or by
any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill
Education, including, but not limited to, in any network or other electronic storage or transmission, or
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Some ancillaries, including electronic and print components, may not be available to customers outside
the United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 5 4
ISBN 978-0-07-802563-1
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Materials from the Certified Management Accountant Examinations, © 2014 by the Institute
of Certified Management Accountants, are reprinted and adapted with permission.
All credits appearing on page or at the end of the book are considered to be an extension of the copyright
page.
Library of Congress Cataloging-in-Publication Data
Garrison, Ray H.
Managerial accounting / Ray H. Garrison, D.B.A., CPA, Professor Emeritus, Brigham Young
University, Eric W. Noreen, Ph.D., CMA, Professor Emeritus, University of Washington, Peter
C. Brewer, Ph.D., CPA, Wake Forest University.—Fifteenth Edition.
pages cm
Includes index.
ISBN 978-0-07-802563-1 (alk. paper)—ISBN 0-07-802563-X (alk. paper)
1. Managerial accounting. I. Noreen, Eric W. II. Brewer, Peter C. III. Title.
HF5657.4.G37 2015
658.15’11—dc23
2013036157
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a
website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill
Education does not guarantee the accuracy of the information presented at these sites.
www.mhhe.com
Dedication
To our families and to our many
colleagues who use this book.
v
About the
Authors
Ray H. Garrison is emeritus professor
of accounting at Brigham Young University, Provo, Utah. He
received his BS and MS degrees from Brigham Young University
and his DBA degree from Indiana University.
As a certified public accountant, Professor Garrison has been
involved in management consulting work with both national
and regional accounting firms. He has published articles in The
Accounting Review, Management Accounting, and other professional
journals. Innovation in the classroom has earned Professor Garrison the Karl G. Maeser
Distinguished Teaching Award from Brigham Young University.
Eric W. Noreen has taught at INSEAD in
France and the Hong Kong Institute of Science and Technology
and is emeritus professor of accounting at the University of
Washington. Currently, he is the Accounting Circle Professor of
Accounting, Fox School of Business, Temple University.
He received his BA degree from the University of Washington
and MBA and PhD degrees from Stanford University. A Certified
Management Accountant, he was awarded a Certificate of
Distinguished Performance by the Institute of Certified Management Accountants.
Professor Noreen has served as associate editor of The Accounting Review and the
Journal of Accounting and Economics. He has numerous articles in academic journals
including: the Journal of Accounting Research; The Accounting Review; the Journal
of Accounting and Economics; Accounting Horizons; Accounting, Organizations and
Society; Contemporary Accounting Research; the Journal of Management Accounting
Research; and the Review of Accounting Studies.
Professor Noreen has won a number of awards from students for his teaching.
vi
Garrison
Noreen
Brewer
Peter C. Brewer is a Lecturer in the
Department of Accountancy at Wake Forest University. Prior
to joining the faculty at Wake Forest, he was an accounting
professor at Miami University for 19 years. He holds a BS
degree in accounting from Penn State University, an MS
degree in accounting from the University of Virginia, and a
PhD from the University of Tennessee. He has published more
than 35 articles in a variety of journals including: Management
Accounting Research; the Journal of Information Systems; Cost Management; Strategic
Finance; the Journal of Accountancy; Issues in Accounting Education; and the Journal
of Business Logistics.
Professor Brewer is a member of the editorial board of the Journal of Accounting
Education and has served on the editorial board of Issues in Accounting Education.
His article “Putting Strategy into the Balanced Scorecard” won the 2003 International
Federation of Accountants’ Articles of Merit competition, and his articles “Using
Six Sigma to Improve the Finance Function” and “Lean Accounting: What’s It All
About?” were awarded the Institute of Management Accountants’ Lybrand Gold
and Silver Medals in 2005 and 2006. He has received Miami University’s Richard
T. Farmer School of Business Teaching Excellence Award.
Prior to joining the faculty at Miami University, Professor Brewer was employed as
an auditor for Touche Ross in the firm’s Philadelphia office. He also worked as an
internal audit manager for the Board of Pensions of the Presbyterian Church (U.S.A.).
Managerial Accounting
F if t e e nt h E d i t i on
vii
Let
Garrison be Your Guide
Garrison truly is the gold
standard of managerial
accounting texts.
Pamela Rouse,
Butler University
It is the ‘Bible’ of
Managerial Accounting.
Mark Motluck,
Anderson University
Garrison is clearly
the best managerial
accounting text
available.
‘Carleton Donchess,
Bridgewater State University’
I am a big fan of this
book. I have taught
this course with a few
other books and this
book does the best job
tying all the concepts
together. When asked I
always refer to this book
as being superior to the
other books that I have
used.
Christopher O’Byrne,
Cuyamaca College
viii
Garrison
For centuries, the lighthouse has provided guidance and safe passage
for sailors. Similarly, Garrison/Noreen/Brewer has successfully guided
millions of students through managerial accounting, helping them sail
smoothly through the course.
Decades ago, lighthouses were still being operated manually. In these
days of digital transformation, lighthouses are run using automatic lamp
changers and other modern devices. In much the same way, Garrison/
Noreen/Brewer has evolved over the years. Today, the Garrison book
not only guides students—accounting majors and other business majors
alike—safely through the course but is enhanced by a number of powerful
new tools to augment student learning and increase student motivation.
McGraw-Hill Connect Accounting and the LearnSmart Advantage Suite
offer a number of features to facilitate student learning. NEW Intelligent
Resource Technology interface for Connect Accounting includes improved
answer acceptance for formatting issues, a general journal application
that looks and feels more like a general ledger software package, and
table entry for select problems so students can complete calculations
online. Animated, narrated Interactive Presentations for each learning
objective teach the core concepts of the text and animated, narrated
Guided Examples connected to practice exercises provide a step-by-step
walkthrough of a similar exercise, assisting students when they need
it most. The student library within Connect gives students access to
additional resources, such as forms for the Applying Excel feature, an
electronic version of the textbook, and more.
The NEW LearnSmart Advantage Suite, powerful products fueled by
the proven McGraw-Hill LearnSmart engine, include additional learning
resources in LearnSmart Achieve and the first ever adaptive eBook
experience in SmartBook. These products utilize data collected from
over 2 million student users and advanced scientific algorithms to ensure
that every minute a student spends studying is the most efficient and
productive minute possible for that individual student.
Just as the lighthouse continues to provide reliable guidance to seafarers,
the Garrison/Noreen/Brewer book continues its tradition of helping students
sail successfully through managerial accounting by always focusing on three
important qualities: relevance, accuracy, and clarity.
Noreen
Brewer
RELEVANCE.
Every effort is made to help students
relate the concepts in this book to the decisions made by working
managers. In the fifteenth edition, the authors have added a new
section to Chapter 1 titled Managerial Accounting: Beyond the
Numbers, which has expanded coverage of leadership skills with
the goal of helping all business students better understand why
managerial accounting is relevant to their future careers. New and
revised In Business boxes throughout the book link chapter concepts
to pertinent real-world examples. Service industry references appear
throughout the chapter narrative and end-of-chapter material to
provide students with relevant context for the material they are
learning. The robust Connect Accounting technology package and
the LearnSmart Advantage Suite include new and exciting tools
to help keep students engaged in the learning process. For these
reasons and many more, a student reading Garrison should never
have to ask “Why am I learning this?”
Ann K. Brooks,
University of New Mexico
The authors have done
a great job explaining
managerial accounting
concepts and providing realworld examples that students
can relate to.
Stephen Benner,
Eastern Illinois University
ACCURACY.
The Garrison book continues to set
the standard for accurate and reliable material in its fifteenth
edition. With each revision, the authors evaluate the book and its
supplements in their entirety, working diligently to ensure that
the end-of-chapter material, solutions manual, and test bank are
consistent, current, and accurate.
CLARITY. Generations of students have praised Garrison
for the friendliness and readability of its writing, but that’s just
the beginning. In the fifteenth edition, the authors have rewritten
various chapters with input and guidance from instructors around
the country to ensure that teaching and learning from Garrison
remains as easy as it can be.
The authors’ steady focus on these three core elements has led
to tremendous results. Managerial Accounting has consistently led
the market, being used by over two million students and earning
a reputation for reliability that other texts aspire to match.
Managerial Accounting
Garrison does a superior job
of introducing Managerial
Accounting and necessary
management skills. In
addition, the textbook
discusses the crucial
topics of why managerial
accounting matters to one’s
career, ethics, and social
responsibility.
It provides simple and clear
explanations of the concepts
with easy to follow examples.
It is ideal for undergraduate
and graduate level
accounting students.
Rong Huang,
Baruch College
The Garrison [text] is clearly
the best written managerial
accounting book that I have
reviewed. The examples
throughout the chapter would
enable a student to use this
book and learn managerial
accounting in an on-line or
hybrid class.
Edna Mitchell,
Polk State College
F if t e e nt h E d i t i on
ix
Garrison’s
Managerial Accounting
includes pedagogical elements that
engage and instruct students without cluttering the pages or interrupting student learning.
Garrison’s key pedagogical tools enhance and support students’ understanding of the
concepts rather than compete with the narrative for their attention.
The Foundational 15
Applying Excel
Available with McGraw-Hill’s Connect® Accounting.
LO4–2, LO4–3, LO4–4,
LO4–5
NEW to the fifteenth edition of Garrison!
Each chapter now contains one Foundational 15 exercise
that includes 15 “building-block” questions related to
one concise set of data. These exercises can be used for
in-class discussion or as homework assignments. They are
found before the Exercises and are available in Connect
Accounting.
The Excel worksheet form that appears below is to be used to recreate the extended example on
pages 153–155. Download the workbook containing this form from the Online Learning Center at
www.mhhe.com/garrison15e. On the website you will also receive instructions about how to use
this worksheet form.
Applying Excel
This end-of-chapter feature links the power of
Excel with managerial accounting concepts by
illustrating how Excel functionality can be used to better
understand accounting data. Applying Excel goes beyond
plugging numbers into a template by providing students
with an opportunity to build their own Excel worksheets
and formulas. Students are then asked “what if”
questions in which they analyze not only how related
pieces of accounting data affect each other but why
they do. Applying Excel immediately precedes the Exercises in twelve of the fifteen chapters in the book and is
also integrated with McGraw-Hill’s Connect ® Accounting, allowing students to practice their skills online with
algorithmically generated datasets.
You should proceed to the requirements below only after completing your worksheet.
Required:
1.
Check your worksheet by changing the beginning work in process inventory to 100
units, the units started into production during the period to 2,500 units, and the units in
ending work in process inventory to 200 units, keeping all of the other data the same as
in the original example. If your worksheet is operating properly, the cost per equivalent
unit for materials should now be $152.50 and the cost per equivalent unit for conversion
gar2563X_ch04_144-186.indd 160
16/09/13 10:31 PM
I like the Foundational 15 and its integration of all the chapter objectives
into one problem that can be reviewed in class.
Melanie Anderson, Slippery Rock University
[Applying Excel is] an excellent way for students to programmatically develop spreadsheet
skills without having to be taught spreadsheet techniques by the instructor. A significant
associated benefit is that students gain more exposure to the dynamics of accounting
information by working with what-if scenarios.
Earl Godfrey, Gardner–Webb University
x
Garrison
Noreen
Brewer
Powerful Pedagogy
Opening Vignette
CHAPTER 4
Each chapter opens with a Business Focus
feature that provides a real-world example
for students, allowing them to see how the
chapter’s information and insights apply to
the world outside the classroom. Learning
Objectives alert students to what they
should expect as they progress through the
chapter.
Kathy Crusto-Way,
Tarrant County College
An excellent text that is
especially good for introductory
managerial accounting classes
because it is organized in a
logical topic development flow.
Elizabeth Widdison,
University of Washington, Seattle
Costing the “Quicker-Picker-Upper”
BUSINESS FO CUS
I like how you engage the
reader with the “Business
Focus” at the beginning of the
chapter.
Process Costing
If you have ever spilled milk,
there is a good chance that
you used Bounty paper
towels to clean up the
mess. Procter & Gamble
(P&G) manufactures Bounty
in two main processing
departments—Paper Making and Paper Converting.
In the Paper Making Department, wood pulp is converted into paper and then
spooled into 2,000 pound
rolls. In the Paper Converting Department, two of the
2,000 pound rolls of paper
are simultaneously unwound
into a machine that creates
a two-ply paper towel that is
decorated, perforated, and
embossed to create texture.
The large sheets of paper
towels that emerge from
this process are wrapped
around a cylindrical cardboard core measuring eight feet in length. Once
enough sheets wrap around the core, the eight foot roll is cut into individual
rolls of Bounty that are sent down a conveyor to be wrapped, packed, and
shipped.
In this type of manufacturing environment, costs cannot be readily traced to
individual rolls of Bounty; however, given the homogeneous nature of the product, the total costs incurred in the Paper Making Department can be spread
uniformly across its output of 2,000 pound rolls of paper. Similarly, the total
costs incurred in the Paper Converting Department (including the cost of the
2,000 pound rolls that are transferred in from the Paper Making Department)
can be spread uniformly across the number of cases of Bounty produced.
P&G uses a similar costing approach for many of its products such as
Tide, Crest toothpaste, and Dawn dishwashing liquid. ■
LEARNING OBJECTIVES
Source: Conversation with Brad Bays, formerly a Procter & Gamble financial executive.
After studying Chapter 4, you should be
able to:
LO4–1
Record the flow of materials, labor,
and overhead through a process
costing system.
LO4–2
Compute the equivalent units of
production using the weightedaverage method.
LO4–3
Compute the cost per equivalent unit
using the weighted-average method.
LO4–4
Assign costs to units using the
weighted-average method.
LO4–5
Prepare a cost reconciliation report.
LO4–6
(Appendix 4A) Compute the
equivalent units of production using
the FIFO method.
LO4–7
(Appendix 4A) Compute the cost per
equivalent unit using the FIFO method.
LO4–8
(Appendix 4A) Assign costs to units
using the FIFO method.
LO4–9
(Appendix 4A) Prepare a cost
reconciliation report using the FIFO
method.
LO4–10
(Appendix 4B) Allocate service
department costs to operating
departments using the direct method.
LO4–11
(Appendix 4B) Allocate service department costs to operating departments
using the step-down method.
144
gar2563X_ch04_144-186.indd 144
9/17/13 6:21 PM
Excellent coverage of the topics. Easy
for students to read.
Sharon Bell,
The University of North Carolina at Pembroke
Managerial Accounting
F if t e e nt h E d i t i on
xi
IN BUSINESS
THE DIFFERENCE BETWEEN LABOR RATES AND LABOR COST
In Business Boxes
The emergence of China as a global competitor has increased the need for managers to understand the difference between labor rates and labor cost. Labor rates reflect the amount paid to
employees per hour or month. Labor costs measure the employee compensation paid per unit of
output. For example, Tenneco has plants in Shanghai, China, and Litchfield, Michigan, that both
manufacture exhaust systems for automobiles. The monthly labor rate per employee at the Shanghai plant ranges from $210–$250, whereas the same figure for the Litchfield plant ranges from
$1,880–$4,064. A naïve interpretation of these labor rates would be to automatically assume that
the Shanghai plant is the lower labor cost facility. A wiser comparison of the two plants’ labor costs
would account for the fact that the Litchfield plant produced 1.4 million exhaust systems in 2005
compared to 400,000 units at the Shanghai plant, while having only 20% more employees than the
Shanghai plant.
In-depth, clear
coverage; interesting
updated examples
in the “In Business”
boxes.
Natalie Allen,
Texas A&M University
Extremely well
written with great
examples, including the
Managerial in Action
segments.
gar2563X_ch04_144-186.indd 149
Loisanne Kattelman,
Weber State University
These helpful boxed features offer a glimpse
into how real companies use the managerial
accounting concepts discussed within the
chapter. Each chapter contains from three to
fourteen of these current examples.
Cost-Volume-Profit Relationships
COMPUTING MARGIN OF SAFETY FOR A SMALL BUSINESS
205
IN BUSINESS
Sam Calagione owns Dogfish Head Craft Brewery, a microbrewery in Rehobeth Beach, Delaware.
He charges distributors as much as $100 per case for his premium beers such as World Wide
Stout. The high-priced microbrews bring in $800,000 in operating income on revenue of $7 million.
Calagione reports that his raw ingredients and labor costs for one case of World Wide Stout are
$30 and $16, respectively. Bottling and packaging costs are $6 per case. Gas and electric costs
are about $10 per case.
If we assume that World Wide Stout is representative of all Dogfish microbrews, then we can
compute the company’s margin of safety in five steps. First, variable cost as a percentage of sales
is 62% [($30 1 $16 1 $6 1 $10)/$100]. Second, the contribution margin ratio is 38% (1 2 0.62).
Third, Dogfish’s total fixed cost is $1,860,000 [($7,000,000 3 0.38) 2 $800,000]. Fourth, the
break-even point in dollar sales is $4,894,737 ($1,860,000/0.38). Fifth, the margin of safety is
16/09/13 10:31 PM
$2,105,263 ($7,000,000 2 $4,894,737).
Source: Patricia Huang, “Château Dogfish,” Forbes, February 28, 2005, pp. 57–59.
Prem Narayan and Bob Luchinni met to discuss the results of Bob’s analysis.
Prem: Bob, everything you have shown me is pretty clear. I can see what impact the
sales manager’s suggestions would have on our profits. Some of those suggestions
are quite good and others are not so good. I am concerned that our margin of safety
is only 50 speakers. What can we do to increase this number?
Bob: Well, we have to increase total sales or decrease the break-even point or both.
Prem: And to decrease the break-even point, we have to either decrease our fixed
expenses or increase our unit contribution margin?
Bob: Exactly.
Prem: And to increase our unit contribution margin, we must either increase our selling
price or decrease the variable cost per unit?
Bob: Correct.
Prem: So what do you suggest?
Bob: Well, the analysis doesn’t tell us which of these to do, but it does indicate we have
a potential problem here.
Prem: If you don’t have any immediate suggestions, I would like to call a general meeting next week to discuss ways we can work on increasing the margin of safety. I
think everyone will be concerned about how vulnerable we are to even small downturns in sales.
MANAGERIAL
ACCOUNTING IN ACTION
THE WRAP-UP
These vignettes depict crossfunctional teams working
together in real-life settings,
working with the products
and services that students
recognize from their own
Cost Structure and Profit Stability
lives. Students are shown
step-by-step how accounting
concepts are implemented
in organizations and how
these concepts are applied to solve everyday business problems. First,
“The Issue” is introduced through a dialogue; the student then walks
through the implementation process; finally, “The Wrap-up” summarizes
the big picture.
CVP Considerations in Choosing a Cost Structure
Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in trading off between these two types of costs.
For example, fixed investments in automated equipment can reduce variable labor costs.
In this section, we discuss the choice of a cost structure. We also introduce the concept of
operating leverage.
Which cost structure is better—high variable costs and low fixed costs, or the opposite?
No single answer to this question is possible; each approach has its advantages. To show
what we mean, refer to the following contribution format income statements for two
gar2563X_ch05_187-232.indd 205
xii
Garrison
Managerial
Accounting in
Action Vignettes
Noreen
16/09/13 10:39 PM
Brewer
Applying Excel
End-of-Chapter Material
Available with McGraw-Hill’s Connect® Accounting.
LO4–2, LO4–3, LO4–4,
LO4–5
Managerial Accounting has earned a reputation for the best
end-of-chapter practice material of any text on the market.
Our problem and case material continues to conform to
AACSB recommendations and makes a great starting point
for class discussions and group projects. When Ray Garrison
first wrote Managerial Accounting, he started with the endof-chapter material, then wrote the narrative in support of it.
This unique approach to textbook authoring not only ensured
consistency between the end-of-chapter material and text
content but also underscored Garrison’s fundamental belief
in the importance of applying theory through practice. It is not
enough for students to read, they must also understand. To
this day, the guiding principle of that first edition remains, and
Garrison’s superior end-of-chapter material continues to provide
accurate, current, and relevant practice for students.
The Excel worksheet form that appears below is to be used to recreate the extended example on
pages 153–155. Download the workbook containing this form from the Online Learning Center at
www.mhhe.com/garrison15e. On the website you will also receive instructions about how to use
this worksheet form.
Exercises
All applicable exercises are available with McGraw-Hill’s Connect® Accounting.
EXERCISE 3–1 Compute the Predetermined Overhead Rate [LO3–1]
Harris Fabrics computes its predetermined overhead rate annually on the basis of direct laborhours. At the beginning of the year, it estimated that 20,000 direct labor-hours would be required
for the period’s estimated level of production. The company also estimated $94,000 of fixed manufacturing overhead expenses for the coming period and variable manufacturing overhead of $2.00
per direct labor-hour. Harris’s actual manufacturing overhead for the year was $123,900 and its
actual total direct labor was 21,000 hours.
Required:
Compute the company’s predetermined overhead rate for the year.
EXERCISE 3–2 Apply Overhead [LO3–2]
Luthan Company uses a predetermined overhead rate of $23.40 per direct labor-hour. This predetermined rate was based on a cost formula that estimated $257,400 of total manufacturing overhead for an estimated activity level of 11,000 direct labor-hours.
The company incurred actual total manufacturing overhead costs of $249,000 and 10,800
total direct labor
hours during the period.
labor-hours
Required:
Determine the amount of manufacturing overhead that would have been applied to all jobs during
the period.
Problems
All applicable problems are available with McGraw-Hill’s Connect® Accounting.
PROBLEM 4–13 Comprehensive Problem; Second Production Department—Weighted-Average Method
[LO4–2, LO4–3, LO4–4, LO4–5]
Old Country Links Inc. produces sausages in three production departments—Mixing, Casing and
Curing, and Packaging. In the Mixing Department, meats are prepared and ground and then mixed
with spices. The spiced meat mixture is then transferred to the Casing and Curing Department,
where the mixture is force-fed into casings and then hung and cured in climate-controlled smoking
chambers. In the Packaging Department, the cured sausages are sorted, packed, and labeled. The
company uses the weighted-average method in its process costing system. Data for September for
the Casing and Curing Department follow:
Percent Completed
Work in process inventory, September 1 . . . . . .
Work in process inventory, September 30 . . . . .
Units
Mixing
Materials
1
1
100%
100%
90%
80%
Mixing
Materials
80%
70%
Cases
gar2563X_ch04_144-186.indd 160
Conversion
16/09/13 10:31 PM
All applicable
cases are
available
Connect® Accounting.
Work
in process inventory,
September
1 .with
. . . .McGraw-Hill’s
........
$1,670
$90
$605
Cost added during September . . . . . . . . . . . . . . . . . . . . .
gar2563X_ch03_083-143.indd 115
The NEW Foundational 15 end-of-chapter feature provides one
set of data and fifteen building-block questions relating to the
quantitative topics covered in that particular chapter, allowing the
student to work through and gain a practical understanding of the
computational material.
Conversion
$81,460
$6,006
CASE 4–19 Second Department—Weighted-Average Method [LO4–2, LO4–3, LO4–4]
$42,490
16/09/13 10:25 PM
“I think we goofed when we hired that new assistant controller,” said Ruth Scarpino, president
of Provost Industries. “Just look at this report that he prepared for last month for the Finishing
Department. I can’t understand it.”
Finishing Department costs:
Work in process inventory, April 1, 450 units; materials
100% complete; conversion 60% complete . . . . . . . . . . . . . . . . . . . . .
Costs transferred in during the month from the
preceding department, 1,950 units . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Materials cost added during the month . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conversion costs incurred during the month . . . . . . . . . . . . . . . . . . . . . .
Total departmental costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
gar2563X_ch04_144-186.indd 166
The Applying Excel end-of-chapter feature integrates key course concepts
and Excel—a software students will encounter in the workplace, whether
they go into accounting or any other business major. With Applying
Excel, students not only gain practice working with Excel software, they
also learn how Excel can be used to present accounting data and how
that data is interrelated. For more information on this feature, please
see page x.
gar2563X_ch04_144-186.indd 170
$ 8,208*
17,940
6,210
13,920
$46,278
Finishing Department costs assigned to:
Units completed and transferred to finished goods,
1,800 units at $25.71 per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process inventory, April 30, 600 units;
materials 0% complete; conversion 35% complete . . . . . . . . . . . . . . .
$46,278
Total departmental costs assigned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$46,278
0
16/09/13 10:32 PM
Strong integration between
chapter content and end-ofchapter exercises/problems.
Clearly written and wellorganized content.
Carleton Donchess,
Bridgewater State University
Well written, well organized,
and good problems to
illustrate concepts
16/09/13 10:32 PM
Eric Typpo,
University of the Pacific
Managerial Accounting
F if t e e nt h E d i t i on
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The resources available
at the online learning
center and through
Connect Plus are
comprehensive, helpful,
and easy to use.
Mary Scarborough,
Tyler Junior College
Clear presentation of
material in the chapter
with robust support
materials through the
text website and Connect.
Author-Written Supplements
Unlike other managerial accounting texts, the book’s authors write all of the
major supplements, ensuring a perfect fit between text and supplements.
For more information on Managerial Accounting’s supplements package,
see page xxiii.
• Instructor’s Manual
• Test bank
• Solutions Manual
Utilizing the Icons
To reflect our service-based economy, the text is replete
with examples from service-based businesses. A helpful
icon distinguishes service-related examples in the text.
David Krug, Johnson County
Community College
Business Ethics are of
growing importance and
the coverage early in the
book is commendable.
The IFRS icon highlights content that may be affected by
the impending change to IFRS and possible convergence
between U.S. GAAP and IFRS.
Heminigild Mpundu,
University of Northern Iowa
Ethics assignments and examples serve as a reminder that
good conduct is vital in business. Icons call out content
that relates to ethical behavior for students.
The writing icon denotes problems that require students
to use critical thinking as well as writing skills to explain
their decisions.
xiv
Garrison
Noreen
Brewer
New to the
Fifteenth Edition
Faculty feedback helps us continue to improve Managerial Accounting. In response to reviewer suggestions, the
authors have made the following changes to the text:
• All chapters have the NEW Foundational 15 end-of-chapter feature.
• New In Business boxes have been added throughout to provide relevant and updated real-world examples
for use in classroom discussion and to support student understanding of key concepts as they read through a
chapter.
• The end-of-chapter practice material has been updated throughout.
• Several chapters (Chapters 2, 8, and 13) now better highlight the dynamic nature and power of Excel as a tool for
managerial accounting.
Chapter 1
This chapter has a new section titled Managerial
Accounting: Beyond the Numbers. It has expanded
coverage of leadership skills and an expanded set of
end-of-chapter exercises.
Chapter 2
The learning objective pertaining to direct and indirect
costs has been moved to the front of the chapter
to improve the students’ ability to understand the
material. Appendix 2A has been overhauled to simplify
the explanation of how to use Microsoft Excel to
perform least-squares regression analysis.
Chapter 3
This chapter has added Appendix 3A: ActivityBased Absorption Costing; this material was formerly
Appendix 7B in the previous edition of the book.
Moving this material to Chapter 3 offers instructors
greater flexibility when determining how to cover
activity-based costing.
Chapter 4
Updated with a new In Business box.
Chapter 5
The assumptions of CVP analysis have been moved
from the end of the chapter to the beginning of the
chapter. The target profit analysis and break-even
analysis learning objectives have been reversed.
Chapter 6
This chapter has added a new learning objective related
to calculating companywide and segment break-even
points for companies with traceable fixed costs. It has
also added a new appendix related to super-variable
costing.
Chapter 7
This chapter has added a new exhibit and accompanying
text to better explain key concepts and terminology
within the chapter.
Managerial Accounting
F if t e e nt h E d i t i on
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Chapter 8
This chapter has been renamed, and we have added new
text and an exhibit to help students better understand
how and why a master budget is created and how
Microsoft Excel can be used to create a financial
planning model that answers “what-if” questions. Two
new end-of-chapter exercises that enable students to
use Microsoft Excel to answer “what-if” questions have
also been added.
Chapter 9
A discussion of the variance analysis cycle and
management by exception has been inserted in the
front of this chapter; this material was previously
included in the standard costing chapter. In response
to customer feedback, we reversed the headings in the
flexible budget performance report. The actual results
are shown in the far-left column and the planning
budget is shown in the far-right column.
Chapter 10
In response to customer feedback, we reversed the
headings in the general model for standard cost
variance analysis. The actual results (AQ 3 AP) are
shown in the far-left column and the flexible budget
(SQ 3 SP) is shown in the far-right column.
Chapter 12
A section illustrating the meaning of a constraint has
been added. Also, several new In Business boxes have
been created.
Chapter 13
The learning objective pertaining to the payback
period has been moved to the front of the chapter.
A Microsoft Excel-based approach has been adopted
for depicting net present value calculations. We have
added a discussion of the behavioral implications of
the simple rate of return method. Appendix 13C has
been completely overhauled so that students can more
easily grasp the impact of income taxes on net present
value analysis.
Chapter 14
This chapter has been updated with new In Business
boxes.
Chapter 15
This chapter’s learning objectives have all been
redefined to emphasize an internal management
perspective. Four new ratios have been added to the text
to further enrich the students’ learning opportunities.
Chapter 11
This chapter has a new Business Focus feature and
two new In Business boxes.
xvi
Garrison
Noreen
Brewer
Learn with Adaptive
Technology
Each innovative product in the LearnSmart Advantage suite is powered by the proven McGraw-Hill LearnSmart engine that has
helped over 2 million student users answer nearly 1.5 billion questions since 2009. All this data has been harnessed to make the
LearnSmart Advantage products the most intelligent, reliable, and effective adaptive learning tools that are available to students.
With products that span the entire learning process from course preparation to providing the first adaptive reading experience,
LearnSmart Advantage is the most widely used and intelligent suite of adaptive study resources available today. This innovative
series of adaptive learning products is designed to deliver demonstrable results in boosting grades, increasing course retention,
and strengthening memory recall.
These powerful products in the LearnSmart Advantage Suite are available with Garrison 15e:
LearnSmart
An adaptive self-study technology that guarantees students are learning faster,
studying more efficiently, and retaining more knowledge. As LearnSmart gets to know
each individual student user, it identifies what a student does or does not know,
ensuring that the most valuable information is presented to maximize each minute of
time spent studying. LearnSmart also pinpoints areas that a student is most likely to
forget and encourages periodic review so that knowledge is truly learned and retained.
Students who use LearnSmart are 35% more likely to complete their class; 13% more
likely to pass their class; and have been proven to improve their performance by a
full letter grade.
How Does LearnSmart work?
A student begins by answering a series of questions related to core concepts and key themes from the selected chapter(s). For each
question answered, a student will be asked to provide a confidence rating, acknowledging their level of knowledge. LearnSmart uses
this information, in tandem with the answer itself, to improve the individual learning path by adjusting which questions to present,
as well as the difficulty of these questions. Throughout the study session, students can monitor their progress by viewing a series of
performance reports that reinforce the content they need to study. They can also compare their score to their classmates and other
students from around the world. LearnSmart revisits the content a student is struggling with to convert knowledge to long-term memory
and improve overall retention of information.
SmartBook
As the first and only adaptive reading experience, SmartBook is changing the way students
read and learn. SmartBook creates a personalized reading experience by highlighting the
most important concepts a student needs to learn at that moment in time. The reading
experience continuously adapts by highlighting content based on what each student knows
and doesn’t know. This ensures that he or she is focused on the content needed to close
specific knowledge gaps, while simultaneously promoting long-term learning. Valuable
reports provide instructors insight as to how students are progressing through textbook
content, and are useful for shaping in-class time or assessment.
Managerial Accounting
F if t e e nt h E d i t i on
xvii
How Does SmartBook Work?
Each SmartBook contains four components: Preview, Read, Practice, and Recharge. Starting with an initial preview of each
chapter and key learning objectives, students read the material and are guided to topics that need the most practice based
on their responses to a continuously adapting diagnostic. Read and practice continue until SmartBook directs students to
recharge important material they are most likely to forget to ensure concept mastery and retention.
LearnSmart Achieve
A revolutionary new learning system that combines a continually adaptive
learning experience with rich, dynamic resources for student achievement.
As a student progresses through LearnSmart Achieve, the program’s
continuously adaptive learning path adjusts to deliver just-in-time videos
catered to his or her specific needs.
FPO
How Does LearnSmart Achieve Work?
LearnSmart Achieve uses a simple three-phase process to help students
achieve academic success:
Tune In—Students are asked a sample series of questions related to a specific learning objective to assess their baseline
understanding of the content and identify knowledge gaps.
Focus—Based on their responses to the Tune In questions, Achieve presents learning resources to teach the concepts that
each student struggles with most.
Practice—After the Focus phase, Achieve asks students a more in-depth series of questions to confirm their understanding
of the key objectives and adjusts accordingly, providing suggested learning resources to assist students in mastering all core
concepts.
xviii
Garrison
Noreen
Brewer
A Market-Leading Book Deserves
Market-Leading Technology
McGraw-Hill Connect ® Accounting
Get Connect Accounting. Get Results.
McGraw-Hills Connect Accounting is a digital teaching and learning environment that gives students the means to better connect
with their coursework, with their instructors, and with the important concepts that they will need to know for success now and in
the future. With Connect Accounting, instructors can deliver assignments, quizzes, and tests easily online. Students can practice
important skills at their own pace and on their own schedule.
Online Assignments
Connect Accounting helps students learn more efficiently by providing feedback and
practice material when and where they need it. Connect Accounting grades homework
automatically and gives immediate feedback on any questions students may have missed.
Intelligent Response Technology (IRT)
IRT is a redesigned student interface for our end-of-chapter assessment content. The
benefits include improved answer acceptance to reduce students’ frustration with
formatting issues (such as rounding). Also, select questions have been redesigned to test
students’ knowledge more fully. They now include tables for students to work through
rather than requiring that all calculations be done offline.
Student Library
The Connect Accounting Student Library gives students access to additional resources
such as recorded lectures, online practice materials, an eBook, and more.
Interactive Presentations
Interactive Presentations, assignable by individual learning objective within Connect,
teach the core concepts of the text in an animated, narrated, and interactive multimedia
format, bringing the key concepts of the course to life–particularly helpful for online
courses and for those audio and visual learners who struggle reading the textbook page
by page.
Guided Examples
Guided Examples, embedded within Connect Accounting, provide a narrated, animated,
step-by-step walkthrough of select exercises similar to those assigned. These short
presentations provide reinforcement when students need it most.
The three best things about Connect Accounting are LearnSmart
(loved it!), Interactive Presentations, and Guided Examples (students
loved them!).
Loisanne Kattelman, Weber State University
Managerial Accounting
F if t e e nt h E d i t i on
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McGraw-Hill Connect Accounting Features
Connect Accounting offers a number of powerful tools and features to make managing assignments easier, so faculty can spend
more time teaching.
Simple Assignment Management and Smart Grading.
With Connect Accounting, creating assignments is easier than ever, so you can spend more time teaching and less time managing.
• Create and deliver assignments easily with selectable end-of-chapter questions and test bank items.
• Go paperless with the eBook and online submission and grading of student assignments.
• Have assignments scored automatically, giving students immediate feedback on their work and side-by-side comparisons
with correct answers.
• Access and review each response; manually change grades or leave comments for students to review.
• Reinforce classroom concepts with practice tests and instant quizzes.
Instructor Library
The Connect Accounting Instructor Library is a repository for additional resources to improve
student engagement in and out of class. You can select and use any asset that enhances your
lecture. The Connect Accounting Instructor Library includes access to the eBook version
of the text, PowerPoint slides, Solutions Manual, Instructor’s Manual, and Test Bank. The
Connect Accounting Instructor Library also allows you to upload your own files.
Student Reports
Connect Accounting keeps instructors informed about how each student, section, and class
is performing, allowing for more productive use of lecture and office hours. The progresstracking enables you to:
• View scored work immediately and track individual or group performance with assignment
and grade reports.
• Access an instant view of student or class performance relative to learning objectives.
• Collect data and generate reports required by many accreditation organizations, such as
AACSB and AICPA.
McGraw-Hill Connect Plus Accounting
•
•
•
•
McGraw-Hill reinvents the textbook learning
experience for the modern student with Connect
Plus Accounting, which provides a seamless
integration of the eBook and Connect Accounting. Connect Plus Accounting provides all of
the Connect Accounting features, as well as:
An integrated media-rich eBook, allowing for anytime, anywhere access to the textbook.
Media-rich capabilities like embedded audio/visual presentations, highlighting, and note sharing.
Dynamic links between the problems or questions you assign to your students and the location in the eBook where the
concept is covered.
A powerful search function to pinpoint and connect key concepts in a snap.
For more information about Connect Accounting, go to www.mcgrawhillconnect.com, or contact your local McGraw-Hill sales
representative.
xx
Garrison
Noreen
Brewer
Tegrity Campus: Lectures 24/7
Tegrity Campus, a McGraw-Hill company, provides a service that makes class time
available 24/7 by automatically capturing every lecture. With a simple one-click startand-stop process, you capture all computer screens and corresponding audio in a format
that is easily searchable, frame by frame. Students can replay any part of any class with easy-to-use browser-based
viewing on a PC or Mac, an iPod, or other mobile device.
Educators know that the more students can see, hear, and experience class resources, the better they learn. In fact,
studies prove it. Tegrity Campus’s unique search feature helps students efficiently find what they need, when they need
it, across an entire semester of class recordings. Help turn your students’ study time into learning moments immediately
supported by your lecture. With Tegrity Campus, you also increase intent listening and class participation by easing
students’ concerns about note-taking. Lecture Capture will make it more likely you will see students’ faces, not the tops
of their heads.
To learn more about Tegrity, watch a 2-minute Flash demo at http://tegritycampus.mhhe.com.
McGraw-Hill Campus
McGraw-Hill Campus is a new one-stop teaching and learning experience available to users
of any learning management system. This institutional service allows faculty and students to
enjoy single sign-on (SSO) access to all McGraw-Hill Higher Education materials, including the
award-winning McGraw-Hill Connect platform, directly from within the institution’s website. McGraw-Hill Campus provides
faculty with instant access to teaching materials (e.g., eTextbooks, Test Banks, PowerPoint slides, animations, and learning
objects), allowing them to browse, search, and use any ancillary content in our vast library. Students enjoy SSO access to
a variety of free products (e.g., quizzes, flash cards, and presentations) and subscription-based products (e.g., McGraw-Hill
Connect). With McGraw-Hill Campus, faculty and students will never need to create another account to access McGraw-Hill
products and services.
McGraw-Hill Create
McGraw-Hill Create is a new, self-service website that allows instructors to create custom course
materials by drawing upon McGraw-Hill’s comprehensive, cross-disciplinary content. Instructors
can add their own content quickly and easily and tap into other rights-secured third-party sources as well, then arrange
the content in a way that makes the most sense for their course. Instructors can even personalize their book with the
course name and information and choose the best format for their students—color print, black-and-white print, or an
eBook. Through Create, instructors can select and arrange the content in a way that makes the most sense for their
course; combine material from different sources and even upload their own content; choose the best format for their
students—print or eBook; and edit and update their course materials as often as they’d like. Begin creating now at www.
mcgrawhillcreate.com.
CourseSmart
Learn Smart. Choose Smart.
CourseSmart is a way for faculty to find and review eTextbooks. It’s also a great option for
students who are interested in accessing their course materials digitally and saving money.
Managerial Accounting
F if t e e nt h E d i t i on
xxi
CourseSmart offers thousands of the most commonly adopted textbooks across hundreds of courses from a wide variety
of higher education publishers. It is the only place for faculty to review and compare the full text of a textbook online,
providing immediate access without the environmental impact of requesting a print exam copy. With the CourseSmart
eTextbook, students can save up to 45 percent off the cost of a print book, reduce their impact on the environment, and
access powerful web tools for learning.
CourseSmart is an online eTextbook, which means users access and view their textbook online when connected to
the Internet. Students can also print sections of the book for maximum portability. CourseSmart eTextbooks are available
in one standard online reader with full text search, notes and highlighting, and e-mail tools for sharing notes between
classmates. For more information on CourseSmart, go to www.coursesmart.com.
McGraw-Hill Customer Experience
At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why our services
don’t stop after you purchase our book. You can email our product specialists 24 hours a day, get product training online,
or search our knowledge bank of Frequently Asked Questions on our support website. For our Customer Experience
Group, call 800-331-5094 or visit www.mhhe.com/support. One of our Technical Support Analysts will assist you in a
timely fashion. You also can take advantage of the “Contact Publisher” link within Connect Accounting.
xxii
Garrison
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Brewer
Instructor Supplements
Assurance of Learning Ready
Many educational institutions today are focused on the notion of
assurance of learning, an important element of some accreditation
standards. Managerial Accounting, 15e, is designed specifically to
support your assurance of learning initiatives with a simple, yet
powerful, solution.
Each test bank question for Managerial Accounting, 15e,
maps to a specific chapter learning outcome/objective listed
in the text. You can use our test bank software, EZ Test, to
easily query for learning outcomes/objectives that directly relate
to the learning objectives for your course. You can then use
the reporting features of EZ Test to aggregate student results
in similar fashion, making the collection and presentation of
assurance of learning data simple and easy.
AACSB Statement
The McGraw-Hill Companies, Inc., is a proud corporate member
of AACSB International. Recognizing the importance and value of
AACSB accreditation, we have sought to recognize the curricula
guidelines detailed in AACSB standards for business accreditation
by connecting selected questions in Managerial Accounting, 15e, to
the general knowledge and skill guidelines found in the AACSB
standards. The statements contained in Managerial Accounting, 15e,
are provided only as a guide for the users of this text. The AACSB
leaves content coverage and assessment clearly within the realm
and control of individual schools, the mission of the school, and the
faculty. The AACSB does also charge schools with the obligation
of doing assessment against their own content and learning goals.
While Managerial Accounting, 15e, and its teaching package make
no claim of any specific AACSB qualification or evaluation, we
have, within Managerial Accounting, 15e, labeled selected questions
according to the six general knowledge and skills areas. The labels
or tags within Managerial Accounting, 15e, are as indicated. There
are, of course, many more within the test bank, the text, and
the teaching package which might be used as a “standard” for
your course. However, the labeled questions are suggested for your
consideration.
Online Learning Center (www.mhhe.com/
garrison15e)
The password protected instructor side of the book’s Online
Learning Center (OLC) houses all the instructor resources you
need to administer your course, including:
• Solutions Manual
• Instructor’s Manual
• Test bank
• Instructor PowerPoint slides
If you choose to use Connect Accounting with Garrison, you will
have access to these same resources via the Instructor Library.
EZ Test Online
Available on the Instructor’s OLC and within the Connect
Instructor Library.
McGraw-Hill’s EZ Test Online is a flexible electronic testing program. The program allows instructors to create tests from bookspecific items. It accommodates a wide range of question types,
plus instructors may add their own questions and sort questions by format. EZ Test Online can also scramble questions and
answers for multiple versions of the same test.
Instructor’s Manual
McGraw-Hill Connect Accounting
McGraw-Hill Connect Accounting offers a
number of powerful tools and features to
make managing your classroom easier. Connect Accounting with
Garrison 15e offers enhanced features and technology to help
both you and your students make the most of your time inside
and outside the classroom. See page xix for more details.
Managerial Accounting
Available on the Instructor’s OLC and within the Connect
Instructor Library.
Extensive chapter-by-chapter lecture notes help with classroom
presentations and contain useful suggestions for presenting
key concepts and ideas. This manual is coordinated with the
PowerPoint slides, making lesson planning even easier.
F if t e e nt h E d i t i on
xxiii
Solutions Manual
Available on the Instructor’s OLC and within the Connect
Instructor Library.
and cases scaled according to difficulty and estimated time for
completion. Solutions to the Applying Excel feature are housed
in the same location as the Solutions Manual and include the
completed Excel forms.
This supplement contains completely worked-out solutions
to all assignment material. In addition, the manual contains
suggested course outlines and a listing of exercises, problems,
xxiv
Garrison
Noreen
Brewer
Student Supplements
McGraw-Hill Connect Accounting
McGraw-Hill Connect Accounting helps
prepare you for your future by enabling
faster learning, more efficient studying, and higher retention of
knowledge. See pages xvii and for more details.
• Check Figures
• Student PowerPoint slides
If your instructor chooses to use Connect Accounting in this
course, you will have access to these same resources via the
Student Library.
Online Learning Center
Applying Excel
www.m hhe. com /gar r i s on1 5 e
The Online Learning Center (OLC) follows Managerial Accounting
chapter by chapter, offering all kinds of supplementary help for
you as you read.
The OLC includes the following resources to help you study more
efficiently:
Forms available on the OLC and in the Connect Student Library.
See page xx for more details.
Check Figures
Available on the OLC and in the Connect Student Library. These
provide key answers for selected problems and cases.
• Applying Excel Forms
• Online Quizzes
Managerial Accounting
F if t e e nt h E d i t i on
xxv
Acknowledgments
Suggestions have been received from many of our colleagues throughout the world. Each of
those who have offered comments and suggestions has our thanks.
The efforts of many people are needed to develop and improve a text. Among these people are
the reviewers and consultants who point out areas of concern, cite areas of strength, and make
recommendations for change. In this regard, the following professors provided feedback that
was enormously helpful in preparing the fifteenth edition of Managerial Accounting:
Helen Adams, University of Washington
Dawn Addington, Central New Mexico Community College
Markus Ahrens, St. Louis Community College—Meramec
Akinloye Akindayomi, University Of
Massachusetts–Dartmouth
David Albrecht, Bowling Green State University
Natalie Allen, Texas A & M University
Vern Allen, Central Florida Community College
Shamir Ally, DeSales University
Jane Austin, Oklahoma City University
John Babich, Kankakee Community College
Ibolya Balog, Cedar Crest College
Scottie Barty, Northern Kentucky University
Eric Bashaw, University of Nevada–Las Vegas
Sharon Bell, University of North Carolina–Pembroke
Stephen Benner, Eastern Illinois University
Scott Berube, University of New Hampshire
Kelly Blacker, Mercy College
Phillip Blanchard, The University of Arizona
Charles Blumer, Saint Charles Community College
Alison Jill Brock, Imperial Valley College
Ann Brooks, University of New Mexico
Rada Brooks, University of California–Berkeley
Myra Bruegger, Southeastern Community College
Georgia Buckles, Manchester Community College
Esther Bunn, Stephen S. Austin State University
Laurie Burney, Mississippi State University
Marci Butterfield, University of Utah–Salt Lake City
Charles Caliendo, University of Minnesota
Donald Campbell, Brigham Young University–Idaho
Don Campodonico, Notre Dame de Namur University
Dana Carpenter, Madison Area Technical College
Wanda Causseaux, Valdosta State University
David Centers, Grand Valley State University
Gayle Chaky, Dutchess Community College
Pamela Champeau, University of Wisconsin Whitewater
Valerie Chau, Palomar College
Star Ciccio, Johnson & Wales University
Richard S. Claire, Canada College
Robert Clarke, Brigham Young University–Idaho
xxvi
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Noreen
Curtis Clements, Abilene Christian University
Darlene Coarts, University of Northern Iowa
Carol Coman, California Lutheran University
Jackie Conrecode, Florida Gulf Coast University
Debora Constable, Georgia Perimeter College
Rita Cook, University of Delaware
Wendy Coons, University of Maine
Michael Cornick, Winthrop University
Deb Cosgrove, University of Nebraska–Lincoln
Kathy Crusto-Way, Tarrant County College
Robin D’Agati, Palm Beach State College, Lake Worth
Patricia Davis, Keystone College
Kathleen Davisson, University of Denver
Nina Doherty, Arkansas Tech University
Patricia Doherty, Boston University
Carleton Donchess, Bridgewater State University
Peter Dorff, Kent State University
David Doyon, Southern New Hampshire University
Emily Drogt, Grand Valley State University
Rita Dufour, Northeast Wisconsin Technical College
Barbara Durham, University of Central Florida
Dean Edmiston, Emporia State University
Barb Eide, University of Wisconsin–Lacrosse
Rafik Elias, California State University–Los Angeles
Richard F. Emery, Linfield College
Ruth Epps, Virginia Commonwealth University
John Eubanks, Independence Community College
Christopher M. Fairchild, Southeastern University
Jack Fatica, Terra Community College
Christos Fatouros, Curry College
Susan Ferguson, James Madison University
Jerry Ferry, University of North Alabama
Calvin Fink, Bethune Cookman University
Virginia Fullwood, Texas A&M University–Commerce
Robert Gannon, Alvernia University
Joseph Gerard, University of Wisconsin Whitewater
Frank Gersich, Monmouth College
Hubert Gill, North Florida
Jeff Gillespie, University of Delaware
Earl Godfrey, Gardner-Webb University
Brewer
Nina Goza, Arkansas Tech University
Marina Grau, HCC–Northwest College
Alfred C. Greenfield, Jr., High Point University
Olen Greer, Missouri State University
Steve Groves, Ivy Tech Community College of
Indiana–Kokomo
Ty Handy, Vermont Technical College
Michael Haselkorn, Bentley University
Susan Hass, Simmons College
John Haverty, St. Joseph’s University
Candice Heino, Anoka Ramsey Community College
Sueann Hely, West Kentucky Community & Technical
College
David Henderson, College of Charleston
Donna Hetzel, Western Michigan University–Kalamazoo
Cynthia Hollenbach, University of Denver
Peg Horan, Wagner College
Rong Huang, Baruch College
Steven Huddart, Penn State
George Hunt, Stephen F Austin State University
Marianne James, California State University, Los Angeles
Gene Johnson, Clark College
Bill Joyce, Minnesota State University–Mankato
Celina Jozsi, University of South Florida
Robert L. Kachur, Richard Stockton College of New Jersey
Loisanne Kattelman, Weber State University
Sue Kattelus, Michigan State University–East Lansing
Nancy Kelly, Middlesex Community College
Anna Kenner, Brevard Community College
Mozaffar Khan, University of Minnesota
Shirly Kleiner, Johnson County Community College
Bill Knowles, University of New Hampshire
Barbara Kren, Marquette University
Jerry Kreuze, Western Michigan University
David Krug, Johnson County Community College
Wikil Kwak, Nebraska Omaha
Ron Lazer, University of Houston–Houston
Dennis Lopez, University of Texas–San Antonio
Don Lucy, Indian River State College
Cathy Lumbattis, Southern Illinois University
Joseph F. Lupino, St. Mary’s College of California
Patrick M. Lynch, Loyola University of New Orleans
Suneel Maheshwari, Marshall University
Linda Malgeri, Kennesaw State University
Carol Mannino, Milwaukee School of Engineering
Steven Markoff, Montclair State University
Linda Marquis, Northern Kentucky University
Melissa Martin, Arizona State University
Michele Martinez, Hillsborough Community College
Josephine Mathias, Mercer Community College
Annie McGowan, Texas A&M University
Michael McLain, Hampton University
Heidi Meier, Cleveland State University
Edna Mitchell, Polk State College
Kim Mollberg, Minnesota State University–Moorhead
Shirley Montagne, Lyndon State College
Andrew Morgret, Christian Brothers University
Jennifer Moriarty, Hudson Valley Community College
Mark Motluck, Anderson University
Heminigild Mpundu, University of Northern Iowa
Matt Muller, Adirondack Community College
Michael Newman, University of Houston–Houston
Christopher O’Byrne, Cuyamaca College
Janet O’Tousa, University of Notre Dame
Mehmet Ozbilgin, Bernard M. Baruch College
Abbie Gail Parham, Georgia Southern
Mary Pearson, Southern Utah University
Judy Peterson, Monmouth College
Yvonne Phang, Bernard M. Baruch College
Debbie Pike, Saint Louis University
Jo Ann Pinto, Montclair State University
Janice Pitera, Broome Community College
Matthew Probst, Ivy Tech Community College
Laura Prosser, Black Hills State University
Herbert Purick, Palm Beach State College–Lake Worth
Vasant Raval, Creighton University
Margaret Reed, University of Cincinnati
Marc B. Robinson, Richard Stockton College of New Jersey
David Rogers, Mesa State College
Lawrence A. Roman, Cuyahoga Community College
Luther Ross, Sr., Central Piedmont Community College
Pamela Rouse, Butler University
Martin Rudnick, William Paterson University
Amal Said, University of Toledo
Mary Scarborough, Tyler Junior College
Rex Schildhouse, Miramar College
Nancy Schrumpf, Parkland College
Pamela Schwer, St. Xavier University
Vineeta Sharma, Florida International University–Miami
Jeffrey Shields, University of Southern Maine
Franklin Shuman, Utah State University–Logan
Lakshmy Sivaratnam, Kansas City Kansas Community College
Talitha Smith, Auburn University–Auburn
Diane Stark, Phoenix College
Dennis Stovall, Grand Valley State University
Gracelyn Stuart-Tuggle, Palm Beach State College–
Boca Campus
Suzy Summers, Furman University
Scott Szilagyi, Fordham University–Bronx
Rita Taylor, University of Cincinnati
Managerial Accounting
F if t e e nt h E d i t i on
xxvii
Lisa Tekmetarovic, Truman College
Teresa Thamer, Brenau University
Amanda Thompson-Abbott, Marshall University
Jerry Thorne, North Carolina A&T State University
Don Trippeer, SUNY College at Oneonta
Robin Turner, Rowan-Cabarrus Community College
Tracy Campbell Tuttle, San Diego Mesa Community College
Eric Typpo, University of the Pacific
Suneel Udpa, University of California–Berkeley
Michael Van Breda, Southern Methodist University
Jayaraman Vijayakumar, Virginia Commonwealth University
Ron Vogel, College of Eastern Utah
David Vyncke, Scott Community College
Terri Walsh, Seminole State College of Florida
Lorry Wasserman, University of Portland
xxviii
Garrison
Noreen
Richard Watson, University of California–Santa Barbara
Victoria Wattigny, Midwestern State University
Betsy Wenz, Indiana University–Kokomo
Robert Weprin, Lourdes College
Gwendolen White, Ball State University
Elizabeth Widdison, University of Washington, Seattle
Val Williams, Duquesne University
Janet Woods, Macon State College
John Woodward, Polk State College
Jia Wu, University OF Massachusetts–Dartmouth
Emily Xu, University of New Hampshire
James Yang, Montclair State University
Jeff Yu, Southern Methodist University
Bert Zarb, Embry-Riddle Aeronautical University
Brewer
We are grateful
for the outstanding support from McGraw-Hill. In particular, we would like to thank
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Development Editor; Kathleen Klehr, Marketing Manager; Pat Plumb, Director of Digital Development; Xin Lin,
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We are grateful to the Institute of Certified Management Accountants for permission to use questions and/or
unofficial answers from past Certificate in Management Accounting (CMA) examinations. Likewise, we thank the
American Institute of Certified Public Accountants, the Society of Management Accountants of Canada, and the
Chartered Institute of Management Accountants (United Kingdom) for permission to use (or to adapt) selected
problems from their examinations. These problems bear the notations CPA, SMA, and CIMA respectively.
Ray H. Garrison • Eric Noreen • Peter Brewer
Managerial Accounting
F if t e e nt h E d i t i on
xxix
Brief Contents
Chapter One
Managerial Accounting: An Overview 1
Chapter Two
Managerial Accounting and Cost Concepts
Chapter Three
Job-Order Costing
Process Costing
Chapter Five
Cost-Volume-Profit Relationships
144
187
Variable Costing and Segment Reporting: Tools for Management
Chapter Seven
Activity-Based Costing: A Tool to Aid Decision Making 286
Chapter Eight
Master Budgeting
Chapter Nine
Flexible Budgets and Performance Analysis
Chapter Ten
342
Standard Costs and Variances
392
427
Chapter Eleven
Performance Measurement in Decentralized Organizations
Chapter Twelve
Differential Analysis: The Key to Decision Making
Chapter Thirteen
Capital Budgeting Decisions
Chapter Fourteen
Statement of Cash Flows
Chapter Fifteen
Appendix A
Pricing Products and Services
Appendix B
Profitability Analysis
Index
741
743
727
583
634
Financial Statement Analysis
Credits
xxx
83
Chapter Four
Chapter Six
27
675
713
531
477
233
Contents
1
Chapter
Chapter
Managerial Accounting:
An Overview 1
What Is Managerial Accounting?
Planning 3
Controlling 3
Decision Making 4
2
Managerial Accounting
and Cost Concepts 27
2
Why Does Managerial Accounting Matter to Your
Career? 5
Business Majors 5
Accounting Majors 7
Professional Certification—A Smart Investment
Cost Classifications for Assigning Costs to Cost
Objects 28
Direct Cost 28
Indirect Cost 29
7
Managerial Accounting: Beyond the Numbers 8
An Ethics Perspective 9
Code of Conduct for Management Accountants 9
A Strategic Management Perspective 11
An Enterprise Risk Management Perspective 12
A Corporate Social Responsibility Perspective 14
A Process Management Perspective 14
A Leadership Perspective 16
Intrinsic Motivation 17
Extrinsic Incentives 17
Cognitive Bias 17
Summary 18
Glossary 18
Questions 19
Exercises 19
Appendix 1A: Corporate Governance 23
Glossary (Appendix 1A) 25
Questions 26
Cost Classifications for Manufacturing
Companies 29
Manufacturing Costs 29
Direct Materials 29
Direct Labor 29
Manufacturing Overhead 30
Nonmanufacturing Costs 30
Cost Classifications for Preparing Financial
Statements 31
Product Costs 31
Period Costs 31
Prime Cost and Conversion Cost 32
Cost Classifications for Predicting Cost Behavior 33
Variable Cost 33
Fixed Cost 34
The Linearity Assumption and the Relevant Range 35
Mixed Costs 37
The Analysis of Mixed Costs 38
Diagnosing Cost Behavior with a Scattergraph Plot
The High-Low Method 40
The Least-Squares Regression Method 42
39
xxxi
xxxii
Contents
Traditional and Contribution Format Income
Statements 44
The Traditional Format Income Statement 44
The Contribution Format Income Statement 45
Cost Classifications for Decision Making
Differential Cost and Revenue 45
Opportunity Cost and Sunk Cost 46
Manufacturing Overhead Costs 96
Applying Manufacturing Overhead 97
The Concept of a Clearing Account 97
Nonmanufacturing Costs 98
Cost of Goods Manufactured 99
Cost of Goods Sold 99
45
Summary 47
Review Problem 1: Cost Terms 48
Review Problem 2: High-Low Method 49
Glossary 49
Questions 51
Applying Excel 51
The Foundational 15 53
Exercises 53
Problems 59
Cases 65
Appendix 2A: Least-Squares Regression Computations
Glossary (Appendix 2A) 69
Exercises and Problems (Appendix 2A) 69
Appendix 2B: Cost of Quality 73
Summary (Appendix 2B) 79
Glossary (Appendix 2B) 79
Exercises and Problems (Appendix 2B) 80
Chapter
3
Job-Order Costing
83
Job-Order Costing—An Overview
84
Job-Order Costing—An Example 85
Measuring Direct Materials Cost 86
Job Cost Sheet 86
Measuring Direct Labor Cost 88
Computing Predetermined Overhead Rates 88
Applying Manufacturing Overhead 89
Manufacturing Overhead—A Closer Look 90
The Need for a Predetermined Rate 90
Choice of an Allocation Base for Overhead Cost
Computation of Unit Costs 92
Job-Order Costing—The Flow of Costs 93
The Purchase and Issue of Materials 94
Issue of Direct and Indirect Materials 94
Labor Cost 95
Schedules of Cost of Goods Manufactured and Cost
of Goods Sold 102
67
Underapplied and Overapplied Overhead—A Closer
Look 104
Computing Underapplied and Overapplied
Overhead 104
Disposition of Underapplied or Overapplied Overhead
Balances 106
Closed Out to Cost of Goods Sold 106
Allocated between Accounts 106
Which Method Should Be Used for Disposing of
Underapplied or Overapplied Overhead? 107
A General Model of Product Cost Flows 107
Multiple Predetermined Overhead Rates 107
Job-Order Costing in Service Companies
Summary 109
Review Problem: Job-Order Costing 109
Glossary 112
Questions 112
Applying Excel 113
The Foundational 15 114
Exercises 115
Problems 122
Cases 129
Appendix 3A: Activity-Based Absorption Costing 130
Glossary (Appendix 3A) 133
Exercises and Problems (Appendix 3A) 133
Appendix 3B: The Predetermined Overhead Rate
and Capacity 138
Exercises and Problems (Appendix 3B) 140
Chapter
91
108
4
Process Costing 144
Comparison of Job-Order and Process Costing 145
Similarities between Job-Order and Process Costing 145
Differences between Job-Order and Process Costing 145
Contents
Cost Flows in Process Costing 146
Processing Departments 146
The Flow of Materials, Labor, and Overhead Costs 147
Materials, Labor, and Overhead Cost Entries 148
Materials Costs 148
Labor Costs 148
Overhead Costs 148
Completing the Cost Flows 149
Equivalent Units of Production 149
Weighted-Average Method 151
Compute and Apply Costs 153
Cost per Equivalent Unit—Weighted-Average
Method 154
Applying Costs—Weighted-Average Method 154
Cost Reconciliation Report 155
Operation Costing
156
Summary 156
Review Problem: Process Cost Flows and Costing
Units 156
Glossary 159
Questions 159
Applying Excel 160
The Foundational 15 161
Exercises 162
Problems 166
Cases 170
Appendix 4A: FIFO Method 171
Exercises and Problems (Appendix 4A) 176
Appendix 4B: Service Department Allocations 179
Exercises and Problems (Appendix 4B) 182
Chapter
5
Cost-Volume-Profit Relationships
187
The Basics of Cost-Volume-Profit (CVP) Analysis 189
Contribution Margin 189
CVP Relationships in Equation Form 191
CVP Relationships in Graphic Form 192
Preparing the CVP Graph 192
Contribution Margin Ratio (CM Ratio) 194
Some Applications of CVP Concepts 196
Change in Fixed Cost and Sales Volume 197
xxxiii
Change in Variable Costs and Sales Volume 198
Change in Fixed Cost, Selling Price, and Sales
Volume 198
Change in Variable Cost, Fixed Cost, and Sales
Volume 199
Change in Selling Price 200
Break-Even and Target Profit Analysis 200
Break-Even Analysis 200
The Equation Method 201
The Formula Method 201
Break-Even in Dollar Sales 201
Target Profit Analysis 202
The Equation Method 202
The Formula Method 203
Target Profit Analysis in Terms of Dollar Sales
The Margin of Safety 204
CVP Considerations in Choosing a Cost Structure
Cost Structure and Profit Stability 205
Operating Leverage 207
Structuring Sales Commissions
209
Sales Mix 209
The Definition of Sales Mix 209
Sales Mix and Break-Even Analysis
Summary 212
Review Problem: CVP Relationships
Glossary 215
Questions 215
Applying Excel 215
The Foundational 15 217
Exercises 218
Problems 223
Cases 230
Chapter
210
212
6
Variable Costing and Segment
Reporting: Tools for Management 233
Overview of Variable and Absorption Costing
Variable Costing 234
Absorption Costing 234
Selling and Administrative Expense 235
Summary of Differences 235
234
203
205
xxxiv
Contents
Variable and Absorption Costing—An Example
Variable Costing Contribution Format Income
Statement 236
Absorption Costing Income Statement 238
236
Reconciliation of Variable Costing with Absorption
Costing Income 239
Advantages of Variable Costing and the Contribution
Approach 242
Enabling CVP Analysis 242
Explaining Changes in Net Operating Income 243
Supporting Decision Making 243
Segmented Income Statements and the Contribution
Approach 244
Traceable and Common Fixed Costs and the Segment
Margin 244
Identifying Traceable Fixed Costs 245
Traceable Costs Can Become Common Costs 245
Segmented Income Statements—An Example 246
Levels of Segmented Income Statements 246
Segmented Income Statements—Decision Making
and Break-Even Analysis 249
Decision Making 249
Break-Even Analysis 250
Segmented Income Statements—Common
Mistakes 251
Omission of Costs 251
Inappropriate Methods for Assigning Traceable Costs
among Segments 252
Failure to Trace Costs Directly 252
Inappropriate Allocation Base 252
Arbitrarily Dividing Common Costs among
Segments 252
Income Statements—An External Reporting
Perspective 253
Companywide Income Statements 253
Segmented Financial Information 253
Summary 254
Review Problem 1: Contrasting Variable and Absorption
Costing 255
Review Problem 2: Segmented Income Statements 257
Glossary 258
Questions 259
Applying Excel 259
The Foundational 15 261
Exercises 262
Problems 269
Cases 277
Appendix 6A: Super-Variable Costing 279
Glossary (Appendix 6A) 282
Exercises and Problems (Appendix 6A) 282
Chapter
7
Activity-Based Costing: A Tool to
Aid Decision Making 286
Activity-Based Costing: An Overview 287
Nonmanufacturing Costs and Activity-Based Costing 287
Manufacturing Costs and Activity-Based Costing 288
Cost Pools, Allocation Bases, and Activity-Based
Costing 288
Designing an Activity-Based Costing (ABC)
System 292
Steps for Implementing Activity-Based Costing 294
Step 1: Define Activities, Activity Cost Pools, and
Activity Measures 294
The Mechanics of Activity-Based Costing 295
Step 2: Assign Overhead Costs to Activity Cost
Pools 295
Step 3: Calculate Activity Rates 299
Step 4: Assign Overhead Costs to Cost Objects 300
Step 5: Prepare Management Reports 303
Comparison of Traditional and ABC Product Costs 306
Product Margins Computed Using the Traditional Cost
System 306
The Differences between ABC and Traditional Product
Costs 307
Targeting Process Improvements
310
Activity-Based Costing and External Reports 311
The Limitations of Activity-Based Costing
Summary 312
Review Problem: Activity-Based Costing
Glossary 314
Questions 315
Applying Excel 315
The Foundational 15 317
312
311
Contents
Exercises 318
Problems 326
Appendix 7A: ABC Action Analysis 331
Summary (Appendix 7A) 336
Review Problem: Activity Analysis Report 337
Glossary (Appendix 7A) 338
Exercises and Problems (Appendix 7A) 338
Chapter
What Is a Budget 343
Advantages of Budgeting 343
Responsibility Accounting 344
Choosing a Budget Period 344
The Self-Imposed Budget 345
Human Factors in Budgeting 345
346
393
368
394
Flexible Budget Variances 398
Activity Variances 398
Revenue and Spending Variances 399
A Performance Report Combining Activity and Revenue
and Spending Variances 401
Performance Reports in Nonprofit Organizations 404
Performance Reports in Cost Centers 404
Flexible Budgets with Multiple Cost Drivers
Preparing the Master Budget 348
The Beginning Balance Sheet 350
The Budgeting Assumptions 350
The Sales Budget 352
The Production Budget 353
Inventory Purchases—Merchandising Company 354
The Direct Materials Budget 355
The Direct Labor Budget 356
The Manufacturing Overhead Budget 357
The Ending Finished Goods Inventory Budget 358
The Selling and Administrative Expense Budget 359
The Cash Budget 360
The Budgeted Income Statement 364
The Budgeted Balance Sheet 365
Summary 367
Review Problem: Budget Schedules
Glossary 369
Questions 370
Applying Excel 370
The Foundational 15 372
Exercises 372
Problems 379
Cases 389
Flexible Budgets and Performance
Analysis 392
Flexible Budgets 394
Characteristics of a Flexible Budget 394
Deficiencies of the Static Planning Budget
How a Flexible Budget Works 397
342
The Master Budget: An Overview
Seeing the Big Picture 347
9
The Variance Analysis Cycle
8
Master Budgeting
Chapter
xxxv
Some Common Errors
404
406
Summary 408
Review Problem: Variance Analysis Using a Flexible
Budget 408
Glossary 410
Questions 410
Applying Excel 410
The Foundational 15 412
Exercises 412
Problems 419
Cases 423
10
Chapter
Standard Costs and Variances 427
Standard Costs—Setting the Stage 428
Setting Direct Materials Standards 429
Setting Direct Labor Standards 430
Setting Variable Manufacturing Overhead
Standards 430
Using Standards in Flexible Budgets 431
xxxvi
Contents
A General Model for Standard Cost Variance
Analysis 432
Responsibility Accounting 479
Cost, Profit, and Investment Centers 479
Cost Center 479
Profit Center 479
Investment Center 479
Using Standard Costs—Direct Materials
Variances 434
The Materials Price Variance 435
The Materials Quantity Variance 436
Using Standard Costs—Direct Labor Variances 437
The Labor Rate Variance 438
The Labor Efficiency Variance 438
Using Standard Costs—Variable Manufacturing
Overhead Variances 439
The Variable Manufacturing Overhead Rate and
Efficiency Variances 440
An Important Subtlety in the Materials Variances
442
Standard Costs—Managerial Implications 444
Advantages of Standard Costs 444
Potential Problems with Standard Costs 444
Summary 445
Review Problem: Standard Costs 445
Glossary 447
Questions 448
Applying Excel 448
The Foundational 15 450
Exercises 450
Problems 453
Cases 458
Appendix 10A: Predetermined Overhead Rates and
Overhead Analysis in a Standard Costing System 459
Glossary (Appendix 10A) 465
Exercises and Problems (Appendix 10A) 465
Appendix 10B: Journal Entries to Record Variances 471
Exercises and Problems (Appendix 10B) 473
Chapter
11
Performance Measurement in Decentralized
Organizations 477
Decentralization in Organizations 478
Advantages and Disadvantages of Decentralization
478
Evaluating Investment Center Performance—Return on
Investment 479
The Return on Investment (ROI) Formula 480
Net Operating Income and Operating Assets
Defined 480
Understanding ROI 480
Criticisms of ROI 482
Residual Income 483
Motivation and Residual Income 485
Divisional Comparison and Residual Income
486
Operating Performance Measures 486
Delivery Cycle Time 487
Throughput (Manufacturing Cycle) Time 487
Manufacturing Cycle Efficiency (MCE) 488
Balanced Scorecard 490
Common Characteristics of Balanced
Scorecards 490
A Company’s Strategy and the Balanced
Scorecard 493
Tying Compensation to the Balanced Scorecard
495
Summary 496
Review Problem: Return on Investment (ROI) and Residual
Income 496
Glossary 497
Questions 497
Applying Excel 498
The Foundational 15 499
Exercises 499
Problems 504
Cases 511
Appendix 11A: Transfer Pricing 512
Review Problem: Transfer Pricing 518
Glossary (Appendix 11A) 519
Exercises and Problems (Appendix 11A) 520
Appendix 11B: Service Department Charges 524
Glossary (Appendix 11B) 528
Exercises and Problems (Appendix 11B) 528
Contents
Chapter
The Foundational 15
Exercises 561
Problems 569
Cases 577
12
Chapter
Capital Budgeting Decisions
536
Adding and Dropping Product Lines and Other
Segments 538
An Illustration of Cost Analysis 538
A Comparative Format 540
Beware of Allocated Fixed Costs 540
The Make or Buy Decision 542
Strategic Aspects of the Make or Buy Decision
An Example of Make or Buy 543
Opportunity Cost
Special Orders
543
545
Utilization of a Constrained Resource 547
What Is a Constraint? 547
Contribution Margin per Unit of the Constrained
Resource 548
Managing Constraints 550
The Problem of Multiple Constraints 551
Joint Product Costs and the Contribution Approach 552
The Pitfalls of Allocation 553
Sell or Process Further Decisions 554
Summary 556
Review Problem: Relevant Costs 556
Glossary 557
Questions 558
Applying Excel 558
583
Capital Budgeting—An Overview 584
Typical Capital Budgeting Decisions 584
Cash Flows versus Net Operating Income 584
Typical Cash Outflows 584
Typical Cash Inflows 585
The Time Value of Money 585
The Payback Method 586
Evaluation of the Payback Method 586
An Extended Example of Payback 587
Payback and Uneven Cash Flows 588
545
Activity-Based Costing and Relevant Costs
560
13
Differential Analysis: The Key to Decision
Making 531
Cost Concepts for Decision Making 532
Identifying Relevant Costs and Benefits 532
Different Costs for Different Purposes 533
An Example of Identifying Relevant Costs
and Benefits 534
Reconciling the Total and Differential Approaches
Why Isolate Relevant Costs? 538
xxxvii
555
The Net Present Value Method 589
The Net Present Value Method Illustrated 589
Recovery of the Original Investment 592
An Extended Example of the Net Present Value
Method 593
The Internal Rate of Return Method 594
The Internal Rate of Return Method Illustrated 594
Comparison of the Net Present Value and Internal Rate
of Return Methods 596
Expanding the Net Present Value Method
Least-Cost Decisions 597
Uncertain Cash Flows
An Example 599
596
599
Preference Decisions—The Ranking of Investment
Projects 600
Internal Rate of Return Method 600
Net Present Value Method 600
The Simple Rate of Return Method
Postaudit of Investment Projects
601
603
xxxviii
Contents
Summary 604
Review Problem: Comparison of Capital Budgeting
Methods 604
Glossary 606
Questions 606
Applying Excel 607
The Foundational 15 608
Exercises 609
Problems 613
Cases 619
Appendix 13A: The Concept of Present Value 621
Review Problem: Basic Present Value Computations 624
Glossary (Appendix 13A) 625
Exercises (Appendix 13A) 626
Appendix 13B: Present Value Tables 627
Appendix 13C: Income Taxes and the Net Present Value
Method 629
Summary (Appendix 13C) 631
Exercises and Problems (Appendix 13C) 631
Interpreting the Statement of Cash Flows 651
Consider a Company’s Specific Circumstances 651
Consider the Relationships among Numbers 652
Free Cash Flow 652
Earnings Quality 653
Summary 653
Review Problem 654
Glossary 658
Questions 658
The Foundational 15 658
Exercises 660
Problems 663
Appendix 14A: The Direct Method of Determining the Net
Cash Provided by Operating Activities 671
Exercises and Problems (Appendix 14A) 673
15
Chapter
14
Financial Statement Analysis
Chapter
Statement of Cash Flows
634
The Statement of Cash Flows: Key Concepts 636
Organizing the Statement of Cash Flows 636
Operating Activities: Direct or Indirect Method? 637
The Indirect Method: A Three-Step Process 638
Step 1 638
Step 2 639
Step 3 640
Investing and Financing Activities: Gross Cash
Flows 640
Property, Plant, and Equipment 641
Retained Earnings 642
Summary of Key Concepts 643
An Example of a Statement of Cash Flows
Operating Activities 646
Step 1 646
Step 2 646
Step 3 647
Investing Activities 647
Financing Activities 648
Seeing the Big Picture 650
644
675
Limitations of Financial Statement
Analysis 676
Comparing Financial Data across Companies 676
Looking beyond Ratios 676
Statements in Comparative and Common-Size
Form 676
Dollar and Percentage Changes on Statements 677
Common-Size Statements 679
Ratio Analysis—Liquidity 681
Working Capital 681
Current Ratio 682
Acid-Test (Quick) Ratio 682
Ratio Analysis—Asset Management 683
Accounts Receivable Turnover 683
Inventory Turnover 684
Operating Cycle 685
Total Asset Turnover 685
Ratio Analysis—Debt Management
Times Interest Earned Ratio 686
Debt-to-Equity Ratio 686
Equity Multiplier 687
686
Contents
Ratio Analysis—Profitability 688
Gross Margin Percentage 688
Net Profit Margin Percentage 688
Return on Total Assets 689
Return on Equity 689
Determining the Markup Percentage 719
Problems with the Absorption Costing Approach
Target Costing 721
Reasons for Using Target Costing 721
An Example of Target Costing 721
Ratio Analysis—Market Performance 690
Earnings per Share 690
Price-Earnings Ratio 691
Dividend Payout and Yield Ratios 691
The Dividend Payout Ratio 691
The Dividend Yield Ratio 692
Book Value per Share 692
Summary of Ratios and Sources of Comparative Ratio
Data 692
Summary 694
Review Problem: Selected Ratios and Financial
Leverage 694
Glossary 697
Questions 697
The Foundational 15 697
Exercises 698
Problems 703
Appendix
A
714
The Economists’ Approach to Pricing
Elasticity of Demand 715
The Profit-Maximizing Price 716
Summary
Glossary
Questions
Exercises
Problems
722
722
722
723
724
Appendix
B
Profitability Analysis
Introduction
727
728
Absolute Profitability
728
Relative Profitability
728
Volume Trade-Off Decisions
Managerial Implications
Pricing Products and Services 713
Introduction
xxxix
715
The Absorption Costing Approach to Cost-Plus
Pricing 718
Setting a Target Selling Price Using the Absorption
Costing Approach 718
Summary 734
Glossary 735
Questions 735
Exercises 735
Problems 736
Cases 739
Credits
Index
741
743
731
733
720
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CHAPTER 1
Managerial Accounting:
An Overview
Managerial Accounting: It’s More
Than Just Crunching Numbers
BUSIN ESS FO CUS
“Creating value through values” is the credo of today’s management accountant. It means that management accountants should maintain an unwavering commitment to ethical values while using their knowledge and skills to
influence decisions that create value for organizational stakeholders. These
skills include managing risks and implementing strategy through planning,
budgeting and forecasting, and decision support. Management accountants
are strategic business partners who understand the financial and operational
sides of the business. They not only report and analyze financial measures,
but also nonfinancial measures of process performance and corporate social
performance. Think of these responsibilities as profits (financial statements),
process (customer focus and satisfaction), people (employee learning and
satisfaction), and planet (environmental stewardship). ■
Source: Conversation with Jeff Thomson, president and CEO of the Institute of Management
Accountants.
1
2
Chapter 1
his chapter explains why managerial accounting is important to the future careers of all business students. It begins by answering two
questions: (1) What is managerial accounting? and (2) Why does managerial
accounting matter to your career? It concludes by discussing six topics—ethics,
strategic management, enterprise risk management, corporate social responsibility, process management, and leadership—that define the business context for applying the
quantitative aspects of managerial accounting.
T
What Is Managerial Accounting?
Many students enrolled in this course will have recently completed an introductory
financial accounting course. Financial accounting is concerned with reporting financial information to external parties, such as stockholders, creditors, and regulators.
Managerial accounting is concerned with providing information to managers for use
within the organization. Exhibit 1–1 summarizes seven key differences between financial and managerial accounting. It recognizes that the fundamental difference between
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Managerial Accounting: An Overview
financial and managerial accounting is that financial accounting serves the needs of those
outside the organization, whereas managerial accounting serves the needs of managers employed inside the organization. Because of this fundamental difference in users,
financial accounting emphasizes the financial consequences of past activities, objectivity and verifiability, precision, and companywide performance, whereas managerial
accounting emphasizes decisions affecting the future, relevance, timeliness, and segment
performance. A segment is a part or activity of an organization about which managers
would like cost, revenue, or profit data. Examples of business segments include product
lines, customer groups (segmented by age, ethnicity, gender, volume of purchases, etc.),
geographic territories, divisions, plants, and departments. Finally, financial accounting
is mandatory for external reports and it needs to comply with rules, such as generally
accepted accounting principles (GAAP) and international financial reporting standards
(IFRS), whereas managerial accounting is not mandatory and it does not need to comply
with externally imposed rules.
As mentioned in Exhibit 1–1, managerial accounting helps managers perform three
vital activities—planning, controlling, and decision making. Planning involves establishing goals and specifying how to achieve them. Controlling involves gathering feedback
to ensure that the plan is being properly executed or modified as circumstances change.
Decision making involves selecting a course of action from competing alternatives. Now
let’s take a closer look at these three pillars of managerial accounting.
Planning
Assume that you work for Procter & Gamble (P&G) and that you are in charge of
the company’s campus recruiting for all undergraduate business majors. In this example,
your planning process would begin by establishing a goal such as: our goal is to recruit
the “best and brightest” college graduates. The next stage of the planning process would
require specifying how to achieve this goal by answering numerous questions such as:
•
•
•
•
•
•
•
How many students do we need to hire in total and from each major?
What schools do we plan to include in our recruiting efforts?
Which of our employees will be involved in each school’s recruiting activities?
When will we conduct our interviews?
How will we compare students to one another to decide who will be extended job offers?
What salary will we offer our new hires? Will the salaries differ by major?
How much money can we spend on our recruiting efforts?
As you can see, there are many questions that need to be answered as part of the planning process. Plans are often accompanied by a budget. A budget is a detailed plan for
the future that is usually expressed in formal quantitative terms. As the head of recruiting
at P&G, your budget would include two key components. First, you would have to work
with other senior managers inside the company to establish a budgeted amount of total
salaries that can be offered to all new hires. Second, you would have to create a budget
that quantifies how much you intend to spend on your campus recruiting activities.
Controlling
Once you established and started implementing P&G’s recruiting plan, you would transition to the control process. This process would involve gathering, evaluating, and
responding to feedback to ensure that this year’s recruiting process meets expectations.
It would also include evaluating the feedback in search of ways to run a more effective
recruiting campaign next year. The control process would involve answering questions
such as:
•
•
Did we succeed in hiring the planned number of students within each major and at
each school?
Did we lose too many exceptional candidates to competitors?
3
4
Chapter 1
•
•
•
•
•
Did each of our employees involved in the recruiting process perform satisfactorily?
Is our method of comparing students to one another working?
Did the on-campus and office interviews run smoothly?
Did we stay within our budget in terms of total salary commitments to new hires?
Did we stay within our budget regarding spending on recruiting activities?
As you can see, there are many questions that need to be answered as part of the control process. When answering these questions your goal would be to go beyond simple
yes or no answers in search of the underlying reasons why performance exceeded or
failed to meet expectations. Part of the control process includes preparing performance
reports. A performance report compares budgeted data to actual data in an effort to
identify and learn from excellent performance and to identify and eliminate sources of
unsatisfactory performance. Performance reports can also be used as one of many inputs
to help evaluate and reward employees.
Although this example focused on P&G’s campus recruiting efforts, we could have
described how planning enables FedEx to deliver packages across the globe overnight,
or how it helped Apple develop and market the iPad. We could have discussed how the
control process helps Pfizer, Eli Lilly, and Abbott Laboratories ensure that their pharmaceutical drugs are produced in conformance with rigorous quality standards, or how
Kroger relies on the control process to keep its grocery shelves stocked. We also could
have looked at planning and control failures such as BP’s massive oil spill in the Gulf of
Mexico. In short, all managers (and that probably includes you someday) perform planning and controlling activities.
Decision Making
Perhaps the most basic managerial skill is the ability to make intelligent, data-driven
decisions. Broadly speaking, many of those decisions revolve around the following
three questions. What should we be selling? Who should we be serving? How should we
execute? Exhibit 1–2 provides examples of decisions pertaining to each of these three
categories.
The left-hand column of Exhibit 1–2 suggests that every company must make
decisions related to the products and services that it sells. For example, each year
Procter & Gamble must decide how to allocate its marketing budget across 25 brands
that each generates over $1 billion in sales as well as other brands that have promising growth potential. Mattel must decide what new toys to introduce to the market. Southwest Airlines must decide what ticket prices to establish for each of its
EXHIBIT 1–2
Examples of Decisions
What should we be selling?
Who should we be serving?
How should we execute?
What products and services
should be the focus of our
marketing efforts?
Who should be the focus of our
marketing efforts?
How should we supply our
parts and services?
What new products and services
should we offer?
Who should we start
serving?
How should we expand our
capacity?
What prices should we charge
for our products and services?
Who should pay price premiums
or receive price discounts?
How should we reduce our
capacity?
What products and services
should we discontinue?
Who should we stop
serving?
How should we improve our
efficiency and effectiveness?
Managerial Accounting: An Overview
thousands of flights per day. General Motors must decide whether to discontinue
certain models of automobiles.
The middle column of Exhibit 1–2 indicates that all companies must make decisions related to the customers that they serve. For example, Sears must decide how to
allocate its marketing budget between products that tend to appeal to male versus female
customers. FedEx must decide whether to expand its services into new markets across
the globe. Hewlett-Packard must decide what price discounts to offer corporate clients
that purchase large volumes of its products. A bank must decide whether to discontinue
customers that may be unprofitable.
The right-hand column of Exhibit 1–2 shows that companies also make decisions
related to how they execute. For example, Boeing must decide whether to rely on outside
vendors such as Goodrich, Saab, and Rolls-Royce to manufacture many of the parts
used to make its airplanes. Cintas must decide whether to expand its laundering and
cleaning capacity in a given geographic region by adding square footage to an existing
facility or by constructing an entirely new facility. In an economic downturn, a manufacturer might have to decide whether to eliminate one 8-hour shift at three plants or to close
one plant. Finally, all companies have to decide among competing improvement opportunities. For example, a company may have to decide whether to implement a new software
system, to upgrade a piece of equipment, or to provide extra training to its employees.
This portion of the chapter has explained that the three pillars of managerial accounting are planning, controlling, and decision making. This book helps prepare you to
become an effective manager by explaining how to make intelligent data-driven decisions, how to create financial plans for the future, and how to continually make progress
toward achieving goals by obtaining, evaluating, and responding to feedback.
Why Does Managerial Accounting Matter to Your Career?
Many students feel anxious about choosing a major because they are unsure if it will
provide a fulfilling career. To reduce these anxieties, we recommend deemphasizing what
you cannot control about the future; instead focusing on what you can control right now.
More specifically, concentrate on answering the following question: What can you do
now to prepare for success in an unknown future career? The best answer is to learn
skills that will make it easier for you to adapt to an uncertain future. You need to become
adaptable!
Whether you end up working in the United States or abroad, for a large corporation, a
small entrepreneurial company, a nonprofit organization, or a governmental entity, you’ll
need to know how to plan for the future, how to make progress toward achieving goals,
and how to make intelligent decisions. In other words, managerial accounting skills are
useful in just about any career, organization, and industry. If you commit energy to this
course, you’ll be making a smart investment in your future—even though you cannot
clearly envision it. Next, we will elaborate on this point by explaining how managerial
accounting relates to the future careers of business majors and accounting majors.
Business Majors
Exhibit 1–3 provides examples of how planning, controlling, and decision making affect
three majors other than accounting—marketing, supply chain management, and human
resource management.
The left-hand column of Exhibit 1–3 describes some planning, controlling, and
decision-making applications in the marketing profession. For example, marketing managers make planning decisions related to allocating advertising dollars across various
communication mediums and to staffing new sales territories. From a control standpoint, they may closely track sales data to see if a budgeted price cut is generating an
5
6
Chapter 1
EXHIBIT 1–3
Relating Managerial Accounting
to Three Business Majors
Supply Chain
Management
Human Resource
Management
How much should
we budget for TV,
print, and Internet
advertising?
How many units
should we plan to
produce next period?
How much should
we plan to spend for
occupational safety
training?
How many
salespeople should we
plan to hire to serve a
new territory?
How much should
we budget for
next period’s utility
expense?
How much should
we plan to spend
on employee
recruitment
advertising?
Did we spend more or
less than expected for
the units we actually
produced?
Is our employee
retention rate
exceeding our
goals?
Are we accumulating
too much inventory
during the holiday
shopping season?
Are we achieving our
goal of reducing the
number of defective
units produced?
Are we meeting our
goal of completing
timely performance
appraisals?
Should we sell our
services as one
bundle or sell them
separately?
Should we transfer
production of a
component part to an
overseas supplier?
Should we hire an
on-site medical staff
to lower our health
care costs?
Should we sell directly
to customers or use a
distributor?
Should we redesign
our manufacturing
process to lower
inventory levels?
Should we hire
temporary workers
or full-time
employees?
Marketing
Planning
Controlling Is the budgeted price
cut increasing unit
sales as expected?
Decision
Making
anticipated increase in unit sales, or they may study inventory levels during the holiday
shopping season so that they can adjust prices as needed to optimize sales. Marketing managers also make many important decisions such as whether to bundle services
together and sell them for one price or to sell each service separately. They may also
decide whether to sell products directly to the customer or to sell to a distributor, who
then sells to the end consumer.
The middle column of Exhibit 1–3 states that supply chain managers have to plan
how many units to produce to satisfy anticipated customer demand. They also need to
budget for operating expenses such as utilities, supplies, and labor costs. In terms of
control, they monitor actual spending relative to the budget, and closely watch operational measures such as the number of defects produced relative to the plan. Supply chain
managers make numerous decisions, such as deciding whether to transfer production of a
component part to an overseas supplier. They also decide whether to invest in redesigning
a manufacturing process to reduce inventory levels.
The right-hand column of Exhibit 1–3 explains how human resource managers
make a variety of planning decisions, such as budgeting how much to spend on occupational safety training and employee recruitment advertising. They monitor feedback
related to numerous management concerns, such as employee retention rates and the
timely completion of employee performance appraisals. They also help make many
important decisions such as whether to hire on-site medical staff in an effort to lower
health care costs, and whether to hire temporary workers or full-time employees in an
uncertain economy.
Managerial Accounting: An Overview
7
For brevity, Exhibit 1–3 does not include all business majors, such as finance, management information systems, and economics. Can you explain how planning, controlling, and decision-making activities would relate to these majors?
Accounting Majors
Many accounting graduates begin their careers working for public accounting firms that
provide a variety of valuable services for their clients. Some of these graduates will build
successful and fulfilling careers in the public accounting industry; however, most will leave
public accounting at some point to work in other organizations. In fact, the Institute of
Management Accountants (IMA) estimates that more than 80% of professional accountants in the United States work in nonpublic accounting environments (www.imanet.org/
about_ima/our_mission.aspx).
The public accounting profession has a strong financial accounting orientation. Its
most important function is to protect investors and other external parties by assuring
them that companies are reporting historical financial results that comply with applicable
accounting rules. Managerial accountants also have strong financial accounting skills.
For example, they play an important role in helping their organizations design and maintain financial reporting systems that generate reliable financial disclosures. However, the
primary role of managerial accountants is to partner with their co-workers within the
organization to improve performance.
Given the 80% figure mentioned above, if you are an accounting major there is a
very high likelihood that your future will involve working for a nonpublic accounting
employer. Your employer will expect you to have strong financial accounting skills, but
more importantly, it will expect you to help improve organizational performance by
applying the planning, controlling, and decision-making skills that are the foundation of
managerial accounting.
A NETWORKING OPPORTUNITY
The Institute of Management Accountants (IMA) is a network of more than 60,000 accounting and
finance professionals from over 120 countries. Every year the IMA hosts a student leadership
conference that attracts 300 students from over 50 colleges and universities. Guest speakers at
past conferences have discussed topics such as leadership, advice for a successful career, how
to market yourself in a difficult economy, and excelling in today’s multigenerational workforce. One
student who attended the conference said, “I liked that I was able to interact with professionals who
are in fields that could be potential career paths for me.” For more information on this worthwhile
networking opportunity, contact the IMA at the phone number and website shown below.
Source: Conversation with Jodi Ryan, the Institute of Management Accountants’ Director, Education/Corporate
Partnerships. (201) 474-1556 or visit its website at www.imanet.org.
Professional Certification—A Smart Investment If you plan to become
an accounting major, the Certified Management Accountant (CMA) designation is a
globally respected credential (sponsored by the IMA) that will increase your credibility,
upward mobility, and compensation. Exhibit 1–4 summarizes the topics covered in the
two-part CMA exam. For brevity, we are not going to define all the terms included in
this exhibit. Its purpose is simply to emphasize that the CMA exam focuses on the planning, controlling, and decision-making skills that are critically important to nonpublic
accounting employers. The CMA’s internal management orientation is a complement to
the highly respected Certified Public Accountant (CPA) exam that focuses on rule-based
compliance—assurance standards, financial accounting standards, business law, and the
tax code. Information about becoming a CMA is available on the IMA’s website (www.
imanet.org) or by calling 1-800-638-4427.
IN BUSINESS
8
Chapter 1
EXHIBIT 1–4
CMA Exam Content
Specifications
IN BUSINESS
Part 1
Financial Planning, Performance, and Control
Planning, budgeting, and forecasting
Performance management
Cost management
Internal controls
Professional ethics
Part 2
Financial Decision Making
Financial statement analysis
Corporate finance
Decision analysis and risk management
Investment decisions
Professional ethics
HOW’S THE PAY?
The Institute of Management Accountants has created the following table that allows individuals to
estimate what their salary would be as a management accountant.
Your
Calculation
Start with this base amount . . . . . . . . . . . . . . . . . . . .
If you are top-level management . . . . . . . . . . . . . . . . .
OR, if you are entry-level management . . . . . . . . . . . .
Number of years in the field _____ . . . . . . . . . . . . . . . .
If you have an advanced degree . . . . . . . . . . . . . . . . .
If you hold the CMA . . . . . . . . . . . . . . . . . . . . . . . . . .
If you hold the CPA . . . . . . . . . . . . . . . . . . . . . . . . . . .
Your estimated salary level . . . . . . . . . . . . . . . . . . . . .
ADD
SUBTRACT
TIMES
ADD
ADD
ADD
$75,807
$28,000
$25,995
$ 700
$13,873
$11,126
$10,193
$75,807
For example, if you make it to top-level management in 10 years, have an advanced degree and a
CMA, your estimated salary would be $135,806 [$75,807 1 $28,000 1 (10 3 700) 1 $13,873 1
$11,126].
Source: Lee Schiffel, David L. Schroeder, and Kenneth A. Smith, “IMA 2011 Salary Survey,” Strategic Finance
June 2012, pp. 29–47.
Managerial Accounting: Beyond the Numbers
Exhibit 1–5 summarizes how each chapter of the book teaches measurement skills that
managers use on the job every day. For example, Chapter 8 teaches you the measurement
skills that managers use to answer the question—how should I create a financial plan
for next year? Chapters 9 and 10 teach you the measurement skills that managers use to
answer the question—how well am I performing relative to my plan? Chapter 7 teaches
you measurement skills related to product, service, and customer profitability. However,
it is vitally important that you also understand managerial accounting involves more than
just “crunching numbers.” To be successful, managers must complement their measurement skills with six business management perspectives that “go beyond the numbers” to
enable intelligent planning, control, and decision making.
Managerial Accounting: An Overview
Chapter Number
The Key Question from a Manager’s Perspective
Chapter 2
What cost classifications do I use for different management
purposes?
Chapters 3 & 4
What is the value of our ending inventory and cost of goods
sold for external reporting purposes?
Chapter 5
How will my profits change if I change my selling price, sales
volume, or costs?
Chapter 6
How should the income statement be presented?
Chapter 7
How profitable is each of our products, services, and
customers?
Chapter 8
How should I create a financial plan for next year?
Chapters 9 & 10
How well am I performing relative to my plan?
Chapter 11
What performance measures should we monitor to ensure
that we achieve our strategic goals?
Chapter 12
How do I quantify the profit impact of pursuing one course of
action versus another?
Chapter 13
How do I make long-term capital investment decisions?
Chapter 14
What cash inflows and outflows explain the change in our
cash balance?
Chapter 15
How can we analyze our financial statements to better
understand our performance?
An Ethics Perspective
Ethical behavior is the lubricant that keeps the economy running. Without that lubricant,
the economy would operate much less efficiently—less would be available to consumers,
quality would be lower, and prices would be higher. In other words, without fundamental
trust in the integrity of business, the economy would operate much less efficiently. Thus,
for the good of everyone—including profit-making companies—it is vitally important
that business be conducted within an ethical framework that builds and sustains trust.
Code of Conduct for Management Accountants The Institute of
Management Accountants (IMA) of the United States has adopted an ethical code
called the Statement of Ethical Professional Practice that describes in some detail the
ethical responsibilities of management accountants. Even though the standards were
developed specifically for management accountants, they have much broader application.
The standards consist of two parts that are presented in full in Exhibit 1–6 (page 10).
The first part provides general guidelines for ethical behavior. In a nutshell, a management accountant has ethical responsibilities in four broad areas: first, to maintain a high
level of professional competence; second, to treat sensitive matters with confidentiality;
third, to maintain personal integrity; and fourth, to disclose information in a credible
fashion. The second part of the standards specifies what should be done if an individual
finds evidence of ethical misconduct.
The ethical standards provide sound, practical advice for management accountants and managers. Most of the rules in the ethical standards are motivated by a very
practical consideration—if these rules were not generally followed in business, then
9
EXHIBIT 1–5
Measurement Skills:
A Manager’s Perspective
10
Chapter 1
EXHIBIT 1–6
IMA Statement of Ethical Professional Practice
Members of IMA shall behave ethically. A commitment to ethical professional practice includes: overarching principles that express our values, and standards that guide our conduct.
PRINCIPLES
IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in
accordance with these principles and shall encourage others within their organizations to adhere to them.
STANDARDS
A member’s failure to comply with the following standards may result in disciplinary action.
I. COMPETENCE
Each member has a responsibility to:
1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills.
2. Perform professional duties in accordance with relevant laws, regulations, and technical standards.
3. Provide decision support information and recommendations that are accurate, clear, concise, and timely.
4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.
II. CONFIDENTIALITY
Each member has a responsibility to:
1. Keep information confidential except when disclosure is authorized or legally required.
2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates’ activities
to ensure compliance.
3. Refrain from using confidential information for unethical or illegal advantage.
III. INTEGRITY
Each member has a responsibility to:
1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts.
2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
3. Abstain from engaging in or supporting any activity that might discredit the profession.
IV. CREDIBILITY
Each member has a responsibility to:
1. Communicate information fairly and objectively.
2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations.
3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with
organization policy and/or applicable law.
RESOLUTION OF ETHICAL CONFLICT
In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical
behavior or resolving an ethical conflict. When faced with ethical issues, you should follow your organization’s
established policies on the resolution of such conflict. If these policies do not resolve the ethical conflict, you should
consider the following courses of action:
1. Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In
that case, present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to
the next management level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors,
board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with
your superior’s knowledge, assuming he or she is not involved. Communication of such problems to authorities
or individuals not employed or engaged by the organization is not considered appropriate, unless you believe
there is a clear violation of the law.
2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other
impartial advisor to obtain a better understanding of possible courses of action.
3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict.
Managerial Accounting: An Overview
TOYOTA ENCOUNTERS MAJOR PROBLEMS
When Toyota Motor Corporation failed to meet its profit targets, the company set an aggressive
goal of reducing the cost of its auto parts by 30%. The quality and safety of the company’s automobiles eventually suffered mightily resulting in recalls, litigation, incentive campaigns, and marketing
efforts that analysts estimate will cost the company more than $5 billion. The car maker’s president, Akio Toyoda, blamed his company’s massive quality lapses on an excessive focus on profits
and market share. Similarly, Jim Press, Toyota’s former top U.S. executive, said the problems were
caused by “financially-oriented pirates who didn’t have the character to maintain a customer-first
focus.”
Sources: Yoshio Takahashi, “Toyota Accelerates Its Cost-Cutting Efforts,” The Wall Street Journal, December
23, 2009, p. B4; Mariko Sanchanta and Yoshio Takahashi, “Toyota’s Recall May Top $5 Billion,” The Wall Street
Journal, March 10, 2010, p. B2; and Norihiko Shirouzu, “Toyoda Rues Excessive Profit Focus,” The Wall Street
Journal, March 2, 2010, p. B3.
the economy and all of us would suffer. Consider the following specific examples of
the consequences of not abiding by the standards:
•
•
•
Suppose employees could not be trusted with confidential information. Then top
managers would be reluctant to distribute such information within the company
and, as a result, decisions would be based on incomplete information and operations
would deteriorate.
Suppose employees accepted bribes from suppliers. Then contracts would tend to
go to the suppliers who pay the highest bribes rather than to the most competent
suppliers. Would you like to fly in aircraft whose wings were made by the subcontractor who paid the highest bribe? Would you fly as often? What would happen to
the airline industry if its safety record deteriorated due to shoddy workmanship on
contracted parts and subassemblies?
Suppose the presidents of companies routinely lied in their annual reports and financial statements. If investors could not rely on the basic integrity of a company’s
financial statements, they would have little basis for making informed decisions.
Suspecting the worst, rational investors would pay less for securities issued by companies and may not be willing to invest at all. As a consequence, companies would
have less money for productive investments—leading to slower economic growth,
fewer goods and services, and higher prices.
Not only is ethical behavior the lubricant for our economy, it is the foundation of
managerial accounting. The numbers that managers rely on for planning, control, and
decision making are meaningless unless they have been competently, objectively, and
honestly gathered, analyzed, and reported. As your career unfolds, you will inevitably
face decisions with ethical implications. Before making such decisions, consider performing the following steps. First, define your alternative courses of action. Second,
identify all of the parties that will be affected by your decision. Third, define how each
course of action will favorably or unfavorably impact each affected party. Once you have
a complete understanding of the decision context, seek guidance from external sources
such as the IMA Statement of Ethical Professional Practice, the IMA Ethics Helpline at
(800) 245-1383, or a trusted confidant. Before executing your decision ask yourself one
final question—would I be comfortable disclosing my chosen course of action on the
front page of The Wall Street Journal?
A Strategic Management Perspective
Companies do not succeed by sheer luck; instead, they need to develop a strategy that
defines how they intend to succeed in the marketplace. A strategy is a “game plan” that
enables a company to attract customers by distinguishing itself from competitors. The focal
11
IN BUSINESS
12
Chapter 1
point of a company’s strategy should be its target customers. A company can only succeed
if it creates a reason for its target customers to choose it over a competitor. These reasons,
or what are more formally called customer value propositions, are the essence of strategy.
Customer value propositions tend to fall into three broad categories—customer
intimacy, operational excellence, and product leadership. Companies that adopt a customer intimacy strategy are in essence saying to their customers, “You should choose us
because we can customize our products and services to meet your individual needs better than our competitors.” Ritz-Carlton, Nordstrom, and Virtuoso (a premium service
travel agency) rely primarily on a customer intimacy value proposition for their success.
Companies that pursue the second customer value proposition, called operational excellence, are saying to their target customers, “You should choose us because we deliver
products and services faster, more conveniently, and at a lower price than our competitors.” Southwest Airlines, Walmart, and Google are examples of companies that succeed
first and foremost because of their operational excellence. Companies pursuing the third
customer value proposition, called product leadership, are saying to their target customers, “You should choose us because we offer higher quality products than our competitors.” Apple, Cisco Systems, and W.L. Gore (the creator of GORE-TEX® fabrics) are
examples of companies that succeed because of their product leadership.1
The plans managers set forth, the variables they seek to control, and the decisions
they make are all influenced by their company’s strategy. For example, Walmart would
not make plans to build ultra-expensive clothing boutiques because these plans would
conflict with the company’s strategy of operational excellence and “everyday low prices.”
Apple would not seek to control its operations by selecting performance measures that
focus solely on cost-cutting because those measures would conflict with its product
leadership customer value proposition. Finally, it is unlikely that Rolex would decide to
implement drastic price reductions for its watches even if a financial analysis indicated
that establishing a lower price might boost short-run profits. Rolex would oppose this
course of action because it would diminish the luxury brand that forms the foundation of
the company’s product leadership customer value proposition.
IN BUSINESS
A FOUR-YEAR WAITING LIST AT VANILLA BICYCLES
Sacha White started Vanilla Bicycles in Portland, Oregon, in 2001. After eight years in business,
he had a four-year backlog of customer orders. He limits his annual production to 40–50 bikes per
year that sell for an average of $7,000 each. He uses a silver alloy that costs 20 times as much
as brass (which is the industry standard) to join titanium tubes together to form a bike frame. White
spends three hours taking a buyer’s measurements to determine the exact dimensions of the bike
frame. He has resisted expanding production because it would undermine his strategy based on
product leadership and customer intimacy. As White said, “If I ended up sacrificing what made
Vanilla special just to make more bikes, that wouldn’t be worth it to me.”
Source: Christopher Steiner, “Heaven on Wheels,” Forbes, April 13, 2009, p. 75.
An Enterprise Risk Management Perspective
Every strategy, plan, and decision involves risks. Enterprise risk management is a process used by a company to identify those risks and develop responses to them that enable
it to be reasonably assured of meeting its goals. The left-hand column of Exhibit 1–7
provides 12 examples of the types of business risks that companies face. They range from
risks that relate to the weather to risks associated with computer hackers, complying
1
These three customer value propositions were defined by Michael Treacy and Fred Wiersema in
“Customer Intimacy and Other Value Disciplines,” Harvard Business Review, Volume 71 Issue 1, pp. 84–93.
Managerial Accounting: An Overview
Examples of Controls to Reduce
Business Risks
Examples of Business Risks
•
Intellectual assets being stolen
from computer files
•
•
Products harming customers
•
•
Losing market share due to the
unforeseen actions of competitors
•
•
Poor weather conditions shutting
down operations
•
•
A website malfunctioning
•
•
A supplier strike halting the flow
of raw materials
•
•
A poorly designed incentive compensation system causing employees to make bad decisions
Financial statements inaccurately
reporting the value of inventory
•
•
An employee stealing assets
•
•
An employee accessing
unauthorized information
•
•
Inaccurate budget estimates
causing excessive or insufficient
production
Failing to comply with equal
employment opportunity laws
•
•
•
•
•
Create firewalls that prohibit computer hackers from corrupting or
stealing intellectual property
Develop a formal and rigorous
new product testing program
Develop an approach for legally
gathering information about
competitors’ plans and practices
Develop contingency plans for
overcoming weather-related
disruptions
Thoroughly test the website before
going “live” on the Internet
Establish a relationship with two
companies capable of providing
needed raw materials
Create a balanced set of performance measures that motivates the
desired behavior
Count the physical inventory on hand
to make sure that it agrees with the
accounting records
Segregate duties so that the same
employee does not have physical
custody of an asset and the responsibility of accounting for it
Create password-protected barriers
that prohibit employees from obtaining information not needed to do
their jobs
Implement a rigorous budget review
process
Create a report that tracks key metrics
related to compliance with the laws
with the law, employee theft, and products harming customers. The right-hand column of
Exhibit 1–7 provides an example of a control that could be implemented to help reduce
each of the risks mentioned in the left-hand column of the exhibit.2 Although these
types of controls cannot completely eliminate risks, they enable companies to proactively manage their risks rather than passively reacting to unfortunate events that have
already occurred.
In managerial accounting, companies use controls to reduce the risk that their plans
will not be achieved. For example, if a company plans to build a new manufacturing
facility within a predefined budget and time frame, it will establish and monitor control
measures to ensure that the project is concluded on time and within the budget. Risk
management is also a critically important aspect of decision making. For example, when
a company quantifies the labor cost savings that it can realize by sending jobs overseas, it
should complement its financial analysis with a prudent assessment of the accompanying
2
Besides using controls to reduce risks, companies can also chose other risk responses, such as accepting or avoiding a risk.
13
EXHIBIT 1–7
Identifying and Controlling
Business Risks
14
Chapter 1
IN BUSINESS
MANAGING THE RISK OF A POWER OUTAGE
Between January and April of 2010, the United States had 35 major power outages. For business
owners, these power outages can be costly. For example, a New York night club called the Smoke
Jazz and Supper Club lost an estimated $1,500 in revenue when a power outage shut down its on-line
reservation system for one night. George Pauli, the owner of Great Embroidery LLC in Mesa, Arizona,
estimates that his company has an average of six power outages every year. Since Pauli’s sewing
machines cannot resume exactly where they leave off when abruptly shut down, each power outage
costs him $120 in lost inventory. Pauli decided to buy $700 worth of batteries to keep his sewing
machines running during power outages. The batteries paid for themselves in less than one year.
Source: Sarah E. Needleman, “Lights Out Means Lost Sales,” The Wall Street Journal, July 22, 2010, p. B8.
risks. Will the overseas manufacturer use child labor? Will the product’s quality decline,
thereby leading to more warranty repairs, customer complaints, and lawsuits? Will the
elapsed time from customer order to delivery dramatically increase? Will terminating
domestic employees diminish morale within the company and harm perceptions within
the community? These are the types of risks that managers should incorporate into their
decision-making processes.
A Corporate Social Responsibility Perspective
Companies are responsible for creating strategies that produce financial results that satisfy stockholders. However, they also have a corporate social responsibility to serve other
stakeholders—such as customers, employees, suppliers, communities, and environmental
and human rights advocates—whose interests are tied to the company’s performance.
Corporate social responsibility (CSR) is a concept whereby organizations consider the
needs of all stakeholders when making decisions. CSR extends beyond legal compliance
to include voluntary actions that satisfy stakeholder expectations. Numerous companies, such as Procter & Gamble, 3M, Eli Lilly and Company, Starbucks, Microsoft,
Genentech, Johnson & Johnson, Baxter International, Abbott Laboratories, KPMG,
PNC Bank, Deloitte, Southwest Airlines, and Caterpillar, prominently describe their
corporate social performance on their websites.
Exhibit 1–8 presents examples of corporate social responsibilities that are of interest
to six stakeholder groups.3 If a company fails to meet the needs of these six stakeholder
groups it can adversely affect its financial performance. For example, if a company pollutes the environment or fails to provide safe and humane working conditions for its
employees, the negative publicity from environmental and human rights activists could
cause the company’s customers to defect and its “best and brightest” job candidates to
apply elsewhere—both of which are likely to eventually harm financial performance.
This explains why in managerial accounting a manager must establish plans, implement
controls, and make decisions that consider impacts on all stakeholders.
A Process Management Perspective
Most companies organize themselves by functional departments, such as the Marketing
Department, the Research and Development Department, and the Accounting Department. These departments tend to have a clearly defined “chain of command” that specifies superior and subordinate relationships. However, effective managers understand that
business processes, more so than functional departments, serve the needs of a company’s
3
Many of the examples in Exhibit 1–8 were drawn from Terry Leap and Misty L. Loughry, “The
Stakeholder-Friendly Firm,” Business Horizons, March/April 2004, pp. 27–32.
Managerial Accounting: An Overview
Companies should provide customers
with:
• Safe, high-quality products that
are fairly priced.
• Competent, courteous, and rapid
delivery of products and services.
• Full disclosure of product-related
risks.
• Easy-to-use information systems
for shopping and tracking orders.
Companies and their suppliers should
provide employees with:
• Safe and humane working
conditions.
• Nondiscriminatory treatment
and the right to organize and file
grievances.
• Fair compensation.
• Opportunities for training, promotion, and personal development.
Companies should provide suppliers
with:
• Fair contract terms and prompt
payments.
• Reasonable time to prepare orders.
• Hassle-free acceptance of timely
and complete deliveries.
• Cooperative rather than unilateral
actions.
Companies should provide
communities with:
• Payment of fair taxes.
• Honest information about plans
such as plant closings.
• Resources that support charities,
schools, and civic activities.
• Reasonable access to media
sources.
Companies should provide
stockholders with:
• Competent management.
• Easy access to complete and
accurate financial information.
• Full disclosure of enterprise risks.
• Honest answers to knowledgeable
questions.
Companies should provide
environmental and human rights
advocates with:
• Greenhouse gas emissions data.
• Recycling and resource
conservation data.
• Child labor transparency.
• Full disclosure of suppliers located
in developing countries.
GREENPEACE LEVERAGES THE POWER OF SOCIAL MEDIA
When Nestlé purchased palm oil from an Indonesian supplier to manufacture Kit-Kat candy bars
Greenpeace International used social media to express its disapproval. Greenpeace claimed that
the Indonesian company destroyed rainforest to create its palm oil plantation; therefore, Nestlé’s
actions were contributing to global warming and endangering orangutans. Greenpeace posted
YouTube videos, added comments to Nestlé’s Facebook page, and sent Twitter Tweets to communicate its message to supporters. At one point, the number of fans on Nestlé’s Facebook page
grew to 95,000, most of them being protesters. Nestlé terminated its relationship with the supplier, which provided 1.25% of Nestlé’s palm oil needs. A Nestlé spokesperson says the difficulty
in responding to social media is to “show that we are listening, which we obviously are, while not
getting involved in a shouting match.”
Source: Emily Steel, “Nestlé Takes a Beating on Social-Media Sites,” The Wall Street Journal, March 29, 2010, p. B5.
most important stakeholders—its customers. A business process is a series of steps that
are followed in order to carry out some task in a business. These steps often span departmental boundaries, thereby requiring managers to cooperate across functional departments. The term value chain is often used to describe how an organization’s functional
departments interact with one another to form business processes. A value chain, as
shown in Exhibit 1–9, consists of the major business functions that add value to a company’s products and services.
15
EXHIBIT 1–8
Examples of Corporate Social
Responsibilities
IN BUSINESS
16
Chapter 1
EXHIBIT 1–9
Business Functions Making Up
the Value Chain
Research
and
Development
Product
Design
Manufacturing
Marketing
Distribution
Customer
Service
Managers need to understand the value chain to be effective in terms of planning,
control, and decision making. For example, if a company’s engineers plan to design a
new product, they must communicate with the Manufacturing Department to ensure that
the product can actually be produced, the Marketing Department to ensure that customers will buy the product, the Distribution Department to ensure that large volumes of
the product can be cost-effectively transported to customers, and the Accounting Department to ensure that the product will increase profits. From a control and decision-making
standpoint, managers also need to focus on process excellence instead of functional performance. For example, if the Purchasing Department focuses solely on minimizing the
cost of purchased materials, this narrowly focused attempt at cost reduction may lead to
greater scrap and rework in the Manufacturing Department, more complaints in the Customer Service Department, and greater challenges in the Marketing Department because
dissatisfied customers are turning their attention to competitors.
Managers frequently use a process management method known as lean thinking, or
what is called Lean Production in the manufacturing sector. Lean Production is a management approach that organizes resources such as people and machines around the flow
of business processes and that only produces units in response to customer orders. It is
often called just-in-time production (or JIT) because products are only manufactured in
response to customer orders and they are completed just-in-time to be shipped to customers. Lean thinking differs from traditional manufacturing methods, which organize work
departmentally and encourage departments to maximize their output even if it exceeds
customer demand and bloats inventories. Because lean thinking only allows production
in response to customer orders, the number of units produced tends to equal the number
of units sold, thereby resulting in minimal inventory. The lean approach also results in
fewer defects, less wasted effort, and quicker customer response times than traditional
production methods.
IN BUSINESS
LOUIS VUITTON IMPLEMENTS LEAN PRODUCTION
Louis Vuitton, headquartered in Paris, France, used lean production to increase its manufacturing capacity without having to build a new factory. It created U-shaped work arrangements for
teams of 10 workers, thereby freeing up 10% more floor space in its factories. The company
was able to hire 300 more workers without adding any square footage. Louis Vuitton also uses
robots and computer programs to reduce wasted leather and the time needed to perform certain tasks.
Source: Christina Passariello, “At Vuitton, Growth in Small Batches,” The Wall Street Journal, June 27, 2011,
pp. B1 and B10.
A Leadership Perspective
An organization’s employees bring diverse needs, beliefs, and goals to the workplace.
Therefore, an important role for organizational leaders is to unite the behaviors of their
fellow employees around two common themes—pursuing strategic goals and making
Managerial Accounting: An Overview
optimal decisions. To fulfill this responsibility, leaders need to understand how intrinsic
motivation, extrinsic incentives, and cognitive bias influence human behavior.
Intrinsic Motivation Intrinsic motivation refers to motivation that comes from
within us. Stop for a moment and identify the greatest accomplishment of your life. Then
ask yourself what motivated you to achieve this goal? In all likelihood, you achieved it
because you wanted to, not because someone forced you to do it. In other words, you
were intrinsically motivated. Similarly, an organization is more likely to prosper when its
employees are intrinsically motivated to pursue its interests. A leader, who employees perceive as credible and respectful of their value to the organization, can increase the extent to
which those employees are intrinsically motivated to pursue strategic goals. As your career
evolves, to be perceived as a credible leader you’ll need to possess three attributes—
technical competence (that spans the value chain), personal integrity (in terms of work
ethic and honesty), and strong communication skills (including oral presentation skills and
writing skills). To be perceived as a leader who is respectful of your co-workers’ value to
the organization, you’ll need to possess three more attributes—strong mentoring skills (to
help others realize their potential), strong listening skills (to learn from your co-workers
and be responsive to their needs), and personal humility (in terms of deferring recognition
to all employees who contribute to the organization’s success). If you possess these six
traits, then you’ll have the potential to become a leader who inspires others to readily and
energetically channel their efforts toward achieving organizational goals.
Extrinsic Incentives Many organizations use extrinsic incentives to highlight
important goals and to motivate employees to achieve them. For example, assume a company establishes the goal of reducing the time needed to perform a task by 20%. In addition, assume the company agrees to pay bonus compensation to its employees if they
achieve the goal within three months. In this example, the company is using a type of
extrinsic incentive known as a bonus to highlight a particular goal and to presumably
motivate employees to achieve it.
While proponents of extrinsic incentives rightly assert that these types of rewards can
have a powerful influence on employee behavior, many critics warn that they can also produce dysfunctional consequences. For example, suppose the employees mentioned above
earned their bonuses by achieving the 20% time reduction goal within three months.
However, let’s also assume that during those three months the quality of the employees’
output plummeted, thereby causing a spike in the company’s repair costs, product returns,
and customer defections. In this instance, did the extrinsic incentive work properly? The
answer is yes and no. The bonus system did motivate employees to attain the time reduction goal; however, it also had the unintended consequences of causing employees to
neglect product quality, thereby increasing repair costs, product returns, and customer
defections. In other words, what may have seemed like a well-intended extrinsic incentive actually produced dysfunctional results for the company. This example highlights an
important leadership challenge that you are likely to face someday—designing financial
compensation systems that fairly reward employees for their efforts without inadvertently
creating extrinsic incentives that motivate them to take actions that harm the company.
Cognitive Bias Leaders need to be aware that all people (including themselves)
possess cognitive biases, or distorted thought processes, that can adversely affect planning, controlling, and decision making. To illustrate how cognitive bias works, let’s consider the scenario of a television “infomercial” where someone is selling a product with
a proclaimed value of $200 for $19.99 if viewers call within the next 30 minutes. Why
do you think the seller claims that the product has a $200 value? The seller is relying on
a cognitive bias called anchoring bias in an effort to convince viewers that a $180 discount is simply too good to pass up. The “anchor” is the false assertion that the product
is actually worth $200. If viewers erroneously attach credibility to this contrived piece of
information, their distorted analysis of the situation may cause them to spend $19.99 on
an item whose true economic value is much less than that amount.
17
18
Chapter 1
While cognitive biases cannot be eliminated, effective leaders should take two steps
to reduce their negative impacts. First, they should acknowledge their own susceptibility to cognitive bias. For example, a leader’s judgment might be clouded by optimism
bias (being overly optimistic in assessing the likelihood of future outcomes) or selfenhancement bias (overestimating ones strengths and underestimating ones weaknesses
relative to others). Second, they should acknowledge the presence of cognitive bias in
others and introduce techniques to minimize their adverse consequences. For example,
to reduce the risks of confirmation bias (a bias where people pay greater attention to
information that confirms their preconceived notions, while devaluing information that
contradicts them) or groupthink bias (a bias where some group members support a course
of action solely because other group members do), a leader may routinely appoint independent teams of employees to assess the credibility of recommendations set forth by
other individuals and groups.
Summary
This chapter defined managerial accounting and explained why it is relevant to business and
accounting majors. It also discussed six topics—ethics, strategic management, enterprise risk
management, corporate social responsibility, process management, and leadership—that define
the context for applying the quantitative aspects of managerial accounting. The most important
goal of this chapter was to help you understand that managerial accounting matters to your future
career regardless of your major. Accounting is the language of business and you’ll need to speak it
to communicate effectively with and influence fellow managers.
Glossary
Budget A detailed plan for the future that is usually expressed in formal quantitative terms. (p. 3)
Business process A series of steps that are followed in order to carry out some task in a
business. (p. 15)
Controlling The process of gathering feedback to ensure that a plan is being properly executed or
modified as circumstances change. (p. 3)
Corporate social responsibility A concept whereby organizations consider the needs of all stakeholders when making decisions. (p. 14)
Decision making Selecting a course of action from competing alternatives. (p. 3)
Enterprise risk management A process used by a company to identify its risks and develop
responses to them that enable it to be reasonably assured of meeting its goals. (p. 12)
Financial accounting The phase of accounting that is concerned with reporting historical financial information to external parties, such as stockholders, creditors, and regulators. (p. 2)
Lean Production A management approach that organizes resources such as people and machines
around the flow of business processes and that only produces units in response to customer
orders. (p. 16)
Managerial accounting The phase of accounting that is concerned with providing information to
managers for use within the organization. (p. 2)
Performance report A report that compares budgeted data to actual data to highlight instances of
excellent and unsatisfactory performance. (p. 4)
Planning The process of establishing goals and specifying how to achieve them. (p. 3)
Segment A part or activity of an organization about which managers would like cost, revenue, or
profit data. (p. 3)
Strategy A company’s “game plan” for attracting customers by distinguishing itself from competitors. (p. 11)
Value chain The major business functions that add value to a company’s products and services,
such as research and development, product design, manufacturing, marketing, distribution,
and customer service. (p. 15)
Managerial Accounting: An Overview
19
Questions
1–1
1–2
1–3
1–4
1–5
1–6
1–7
1–8
1–9
1–10
1–11
1–12
1–13
1–14
1–15
How does managerial accounting differ from financial accounting?
Pick any major television network and describe some planning and control activities that
its managers would engage in.
If you had to decide whether to continue making a component part or to begin buying
the part from an overseas supplier, what quantitative and qualitative factors would influence your decision?
Why do companies prepare budgets?
Why is managerial accounting relevant to business majors and their future careers?
Why is managerial accounting relevant to accounting majors and their future careers?
Pick any large company and describe its strategy using the framework in the chapter.
Why do management accountants need to understand their company’s strategy?
Pick any large company and describe three risks that it faces and how it responds to
those risks.
Provide three examples of how a company’s risks can influence its planning, controlling,
and decision-making activities.
Pick any large company and explain three ways that it could segment its companywide
performance.
Locate the website of any company that publishes a corporate social responsibility report
(also referred to as a sustainability report). Describe three nonfinancial performance
measures included in the report. Why do you think the company publishes this report?
Why do companies that implement Lean Production tend to have minimal inventories?
Why are leadership skills important to managers?
Why is ethical behavior important to business?
Multiple-choice questions are provided on the text website at www.mhhe.com/garrison15e.
Exercises
For this chapter, LearnSmart and Interactive Presentations are available with
McGraw-Hill’s Connect® Accounting.
EXERCISE 1–1 Planning and Control
Many companies use budgets for three purposes. First, they use them to plan how to deploy resources to
best serve customers. Second, they use them to establish challenging goals, or stretch targets, to motivate
employees to strive for exceptional results. Third, they use them to evaluate and reward employees.
Assume that you are a sales manager working with your boss to create a sales budget for next
year. Once the sales budget is established, it will influence how other departments within the company plan to deploy their resources. For example, the manufacturing manager will plan to produce
enough units to meet budgeted unit sales. The sales budget will also be instrumental in determining
your pay raise, potential for promotion, and bonus. If actual sales exceed the sales budget, it bodes
well for your career. If actual sales are less than budgeted sales, it will diminish your financial
compensation and potential for promotion.
Required:
1.
2.
3.
4.
5.
6.
Do you think it would be appropriate for your boss to establish the sales budget without any
input from you? Why?
Do you think the company would be comfortable with allowing you to establish the sales
budget without any input from your boss? Why?
Assume the company uses its sales budget for only one purpose—planning to deploy resources
in a manner that best serves customers. What thoughts would influence your estimate of future
sales as well as your boss’s estimate of future sales?
Assume the company uses its sales budget for only one purpose—motivating employees to
strive for exceptional results. What thoughts would influence your estimate of future sales as
well as your boss’s estimate of future sales?
Assume the company uses its sales budget for only one purpose—to determine your pay raise,
potential for promotion, and bonus. What thoughts would influence your estimate of future
sales as well as your boss’s estimate of future sales?
Assume the sales budget is used for all three purposes described in questions 3–5. Describe any
conflicts or complications that might arise when using the sales budget for these three purposes.
20
Chapter 1
EXERCISE 1–2 Controlling
Assume that you work for an airline unloading luggage from airplanes. Your boss has said that,
on average, each airplane contains 100 pieces of luggage. Furthermore, your boss has stated that
you should be able to unload 100 pieces of luggage from an airplane in 10 minutes. Today an airplane arrived with 150 pieces of luggage and you unloaded all of it in 13 minutes. After finishing
with the 150 pieces of luggage, your boss yelled at you for exceeding the 10 minute allowance for
unloading luggage from an airplane.
Required:
How would you feel about being yelled at for taking 13 minutes to unload 150 pieces of luggage?
How does this scenario relate to the larger issue of how companies design control systems?
EXERCISE 1–3 Decision Making
Exhibit 1–2 (see page 4) includes 12 questions related to 12 types of decisions that companies
often face. In the chapter, these 12 decisions were discussed within the context of for-profit companies; however, they are also readily applicable to nonprofit organizations. To illustrate this point,
assume that you are a senior leader, such as a president, provost, or dean, in a university setting.
Required:
For each of the 12 decisions in Exhibit 1–2, provide an example of how that type of decision might
be applicable to a university setting.
EXERCISE 1–4 Ethics and the Manager
Richmond, Inc., operates a chain of 44 department stores. Two years ago, the board of directors of
Richmond approved a large-scale remodeling of its stores to attract a more upscale clientele.
Before finalizing these plans, two stores were remodeled as a test. Linda Perlman, assistant
controller, was asked to oversee the financial reporting for these test stores, and she and other
management personnel were offered bonuses based on the sales growth and profitability of these
stores. While completing the financial reports, Perlman discovered a sizable inventory of outdated
goods that should have been discounted for sale or returned to the manufacturer. She discussed the
situation with her management colleagues; the consensus was to ignore reporting this inventory as
obsolete because reporting it would diminish the financial results and their bonuses.
Required:
1.
2.
According to the IMA’s Statement of Ethical Professional Practice, would it be ethical for
Perlman not to report the inventory as obsolete?
Would it be easy for Perlman to take the ethical action in this situation?
(CMA, adapted)
EXERCISE 1–5 Strategy
The table below contains the names of six companies.
Required:
For each company, categorize its strategy as being focused on customer intimacy, operational
excellence, or product leadership. If you wish to improve your understanding of each company’s
customer value proposition before completing the exercise, review its most recent annual report.
To obtain electronic access to this information, perform an Internet search on each company’s
name followed by the words “annual report.”
Company
1.
2.
3.
4.
5.
6.
Deere . . . . . . . . . . . . . . . . . . . . .
FedEx . . . . . . . . . . . . . . . . . . . . .
State Farm Insurance . . . . . . . . .
BMW . . . . . . . . . . . . . . . . . . . . .
Amazon.com . . . . . . . . . . . . . . .
Charles Schwab . . . . . . . . . . . . .
Strategy
?
?
?
?
?
?
EXERCISE 1–6 Enterprise Risk Management
The table below refers to seven industries.
Required:
For each industry, identify one important risk faced by the companies that compete within that industry. Also, describe one control that companies could use to reduce the risk that you have identified.
Managerial Accounting: An Overview
Industry
1.
2.
3.
4.
5.
6.
7.
Type of Risk
Control to
Reduce the Risk
Airlines (e.g., Delta Airlines) . . . . . . . . . . . . . . . . .
Pharmaceutical drugs (e.g., Merck) . . . . . . . . . . .
Package delivery (e.g., United Parcel Service) . . .
Banking (e.g., Bank of America) . . . . . . . . . . . . . .
Oil & gas (e.g., Exxon Mobil) . . . . . . . . . . . . . . . .
E-commerce (e.g., eBay) . . . . . . . . . . . . . . . . . . .
Automotive (e.g., Toyota) . . . . . . . . . . . . . . . . . . .
EXERCISE 1–7 Ethics in Business
Consumers and attorney generals in more than 40 states accused a prominent nationwide chain of
auto repair shops of misleading customers and selling them unnecessary parts and services, from
brake jobs to front-end alignments. Lynn Sharpe Paine reported the situation as follows in “Managing for Organizational Integrity,” Harvard Business Review, Volume 72 Issue 3:
In the face of declining revenues, shrinking market share, and an increasingly competitive
market . . . management attempted to spur performance of its auto centers. . . . The automotive service advisers were given product-specific sales quotas—sell so many springs, shock
absorbers, alignments, or brake jobs per shift—and paid a commission based on sales. . . .
[F]ailure to meet quotas could lead to a transfer or a reduction in work hours. Some employees spoke of the “pressure, pressure, pressure” to bring in sales.
This pressure-cooker atmosphere created conditions under which employees felt that the
only way to satisfy top management was by selling products and services to customers that
they didn’t really need.
Suppose all automotive repair businesses routinely followed the practice of attempting to sell
customers unnecessary parts and services.
Required:
1.
2.
How would this behavior affect customers? How might customers attempt to protect themselves against this behavior?
How would this behavior probably affect profits and employment in the automotive service
industry?
EXERCISE 1–8 Cognitive Bias
In the 1970s, one million college-bound students were surveyed and asked to compare themselves
to their peers. Some of the key findings of the survey were as follows:
a. 70% of the students rated themselves as above average in leadership ability, while only 2%
rated themselves as below average in this regard.
b. With respect to athletic skills, 60% of the students rated their skills as above the median and
only 6% of students rated themselves as below the median.
c. 60% of the students rated themselves in the top 10% in terms of their ability to get along with
others, while 25% of the students felt that they were in the top 1% in terms of this interpersonal skill.
Required:
What type of cognitive bias reveals itself in the data mentioned above? How might this cognitive
bias adversely influence a manager’s planning, controlling, and decision-making activities? What
steps could managers take to reduce the possibility that this cognitive bias would adversely influence their actions?
Source: Dan Lovallo and Daniel Kahneman, “Delusions of Success: How Optimism Undermines
Executives’ Decisions,” Harvard Business Review, July 2003, pp. 56–63.
EXERCISE 1–9 Ethics and Decision Making
Assume that you are the chairman of the Department of Accountancy at Mountain State University.
One of the accounting professors in your department, Dr. Candler, has been consistently and uniformly regarded by students as an awful teacher for more than 10 years. Other accounting professors within your department have observed Dr. Candler’s classroom teaching and they concur that
his teaching skills are very poor. However, Dr. Candler was granted tenure 12 years ago, thereby
ensuring him life-long job security at Mountain State University.
21
22
Chapter 1
Much to your surprise, today you received a phone from an accounting professor at Oregon
Coastal University. During this phone call you are informed that Oregon Coastal University is on
the verge of making a job offer to Dr. Candler. However, before extending the job offer, the faculty
at Oregon Coastal wants your input regarding Dr. Candler’s teaching effectiveness while at Mountain State University.
Required:
How would you respond to the professor from Oregon Coastal University? What would you say
about Dr. Candler’s teaching ability? Would you describe your answer to this inquiry as being ethical? Why?
EXERCISE 1–10 Corporate Social Responsbility
In his book Capitalism and Freedom, economist Milton Friedman wrote on page 133: “There is
one and only one social responsibility of business—to use its resources and engage in activities
designed to increase its profits so long as it . . . engages in open and free competition, without
deception or fraud.”
Required:
Explain why you agree or disagree with this quote.
EXERCISE 1–11 Intrinsic Motivation and Extrinsic Incentives
In a Harvard Business Review article titled “Why Incentive Plans Cannot Work,” (Volume 71, Issue 5)
author Alfie Kohn wrote: “Research suggests that, by and large, rewards succeed at securing one
thing only: temporary compliance. When it comes to producing lasting change in attitudes and
behavior, however, rewards, like punishment, are strikingly ineffective. Once the rewards run out,
people revert to their old behaviors. . . . Incentives, a version of what psychologists call extrinsic
motivators, do not alter the attitudes that underlie our behaviors. They do not create an enduring commitment to any value or action. Rather, incentives merely—and temporarily—change what we do.”
Required:
1.
2.
3.
Do you agree with this quote? Why?
As a manager, how would you seek to motivate your employees?
As a manager, would you use financial incentives to compensate your employees? If so, what
would be the keys to using them effectively? If not, then how would you compensate your
employees?
EXERCISE 1–12 Cognitive Bias and Decision Making
During World War II, the U.S. military was studying its combat-tested fighter planes to determine
the parts of the plane that were most vulnerable to enemy fire. The purpose of the study was to
identify the most vulnerable sections of each plane and then take steps to reinforce those sections
to improve pilot safety and airplane durability. The data gathered by the U.S. military showed that
certain sections of its combat-tested fighter planes were consistently hit more often with enemy
fire than other sections of the plane.
Required:
1.
2.
Would you recommend reinforcing the sections of the plane that were hit most often by enemy
fire, or would you reinforce the sections that were hit less frequently by enemy fire? Why?
Do you think cognitive bias had the potential to influence the U.S. military’s decision-making
process with respect to reinforcing its fighter planes?
Source: Jerker Denrell, “Selection Bias and the Perils of Benchmarking,” Harvard Business
Review, Volume 83, Issue 4, pp. 114–119.
EXERCISE 1–13 Ethics and Decision Making
Assume that you just completed a December weekend vacation to a casino within the United
States. During your trip you won $10,000 gambling. When the casino exchanged your chips for
cash they did not record any personal information, such as your driver’s license number or social
security number. Four months later while preparing your tax returns for the prior year, you stop to
contemplate the fact that the Internal Revenue Service requires taxpayers to report all gambling
winnings on Form 1040.
Required:
Would you report your gambling winnings to the Internal Revenue Service so that you could pay
federal income taxes on those winnings? Do you believe that your actions are ethical? Why?
Managerial Accounting: An Overview
Appendix 1A: Corporate Governance
Effective corporate governance enhances stockholders’ confidence that a company is
being run in their best interests rather than in the interests of top managers. Corporate
governance is the system by which a company is directed and controlled. If properly
implemented, the corporate governance system should provide incentives for the board
of directors and top management to pursue objectives that are in the interests of the company’s owners and it should provide for effective monitoring of performance.1
Unfortunately, history has repeatedly shown that unscrupulous top managers, if
unchecked, can exploit their power to defraud stockholders. This unpleasant reality
became all too clear in 2001 when the fall of Enron kicked off a wave of corporate
scandals. These scandals were characterized by financial reporting fraud and misuse of
corporate funds at the very highest levels—including CEOs and CFOs. While this was
disturbing in itself, it also indicated that the institutions intended to prevent such abuses
weren’t working, thus raising fundamental questions about the adequacy of the existing
corporate governance system. In an attempt to respond to these concerns, the U.S. Congress passed the most important reform of corporate governance in many decades—The
Sarbanes-Oxley Act of 2002.
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 was intended to protect the interests of those who
invest in publicly traded companies by improving the reliability and accuracy of corporate financial reports and disclosures. We would like to highlight six key aspects of the
legislation.2
First, the Act requires that both the CEO and CFO certify in writing that their company’s financial statements and accompanying disclosures fairly represent the results of
operations—with possible jail time if a CEO or CFO certifies results that they know
are false. This creates very powerful incentives for the CEO and CFO to ensure that the
financial statements contain no misrepresentations.
Second, the Act established the Public Company Accounting Oversight Board to provide additional oversight over the audit profession. The Act authorizes the Board to conduct investigations, to take disciplinary actions against audit firms, and to enact various
standards and rules concerning the preparation of audit reports.
Third, the Act places the power to hire, compensate, and terminate the public
accounting firm that audits a company’s financial reports in the hands of the audit
committee of the board of directors. Previously, management often had the power to
hire and fire its auditors. Furthermore, the Act specifies that all members of the audit
committee must be independent, meaning that they do not have an affiliation with the
company they are overseeing, nor do they receive any consulting or advisory compensation from the company.
Fourth, the Act places important restrictions on audit firms. Historically, public
accounting firms earned a large part of their profits by providing consulting services to
the companies that they audited. This provided the appearance of a lack of independence
because a client that was dissatisfied with an auditor’s stance on an accounting issue
might threaten to stop using the auditor as a consultant. To avoid this possible conflict
of interests, the Act prohibits a public accounting firm from providing a wide variety of
nonauditing services to an audit client.
Fifth, the Act requires that a company’s annual report contain an internal control
report. Internal controls are put in place by management to provide assurance to investors that financial disclosures are reliable. The report must state that it is management’s
1
This definition of corporate governance was adapted from the 2004 report titled OECD Principles of
Corporate Governance published by the Organization for Economic Co-Operation and Development.
2
A summary of the Sarbanes-Oxley Act of 2002 can be obtained at www.soxlaw.com.
23
24
Chapter 1
responsibility to establish and maintain adequate internal controls and it must contain
an assessment by management of the effectiveness of its internal control structure. The
internal control report is accompanied by an opinion from the company’s audit firm
as to whether management has maintained effective internal control over its financial
reporting process.
Finally, the Act establishes severe penalties of as many as 20 years in prison for
altering or destroying any documents that may eventually be used in an official proceeding and as many as 10 years in prison for managers who retaliate against a so-called
whistle-blower who goes outside the chain of command to report misconduct. Collectively, these six aspects of the Sarbanes-Oxley Act of 2002 were intended to help reduce
the incidence of fraudulent financial reporting.
Internal Control—A Closer Look
Internal control is an important concept for all managers to understand and, although
you may not be aware of it, it also plays an important role in your personal life. Internal
control is a process designed to provide reasonable assurance that objectives are being
achieved. For example, one objective for your personal life is to live to a ripe old age.
Unfortunately, there are risks that we all encounter that may prohibit us from achieving
this objective. For example, we may die prematurely due to a heart attack, a car accident,
or a house fire. To reduce the risk of these unfortunate events occurring, we implement
controls in our lives. We may exercise regularly and make nutritional food choices to
reduce the likelihood of a heart attack. We always wear seat belts and instruct our friends
to prohibit us from drinking alcohol and driving a vehicle to reduce the risk of a fatal car
crash. We install fire detectors in our homes to reduce the risk of a fatal fire. In short,
internal controls are an integral part of our daily lives.
A company uses internal controls to provide reasonable assurance that its financial
reports are reliable.3 Its financial statements may contain intentional or unintentional
errors for three reasons. First, the statements may erroneously exclude some transactions.
For example, the income statement may fail to include legitimate expenses. Second, the
statements may improperly include some transactions. For example, the income statement may include sales revenue that was not earned during the current period. Third, the
statements may include transactions that have been recorded erroneously. For example,
an expense or sales transaction may be recorded at the wrong amount.
Exhibit 1A–1 describes seven types of internal controls that companies use to reduce
the risk that these types of errors will occur. Each item in the exhibit is labeled as a
preventive control and/or a detective control. A preventive control deters undesirable
events from occurring. A detective control detects undesirable events that have already
occurred. Requiring authorizations for certain types of transactions is a preventive control. For example, companies frequently require that a specific senior manager sign all
checks above a particular dollar amount to reduce the risk of an inappropriate cash disbursement. Reconciliations are a detective control. If you have ever compared a bank
statement to your checkbook to resolve any discrepancies, then you have performed a
type of reconciliation known as a bank reconciliation. This is a detective control because
you are seeking to identify any mistakes already made by the bank or existing mistakes
in your own records.
Segregation of duties is a preventive control that separates responsibilities for authorizing transactions, recording transactions, and maintaining custody of the related assets.
For example, the same employee should not have the ability to authorize inventory
purchases, account for those purchases, and manage the inventory storeroom. Physical
safeguards prevent unauthorized employees from having access to assets such as inventories and computer equipment. Performance reviews are a detective control performed
3
Companies also use internal controls to achieve efficient and effective operations and to ensure compliance with applicable laws and regulations.
Managerial Accounting: An Overview
Type of Control
Classification
Description
Authorizations
Preventive
Requiring management to formally
approve certain types of transactions.
Reconciliations
Detective
Relating data sets to one another to
identify and resolve discrepancies.
Segregation of
duties
Preventive
Separating responsibilities related to
authorizing transactions, recording
transactions, and maintaining custody
of the related assets.
Physical
safeguards
Preventive
Using cameras, locks, and physical
barriers to protect assets.
Performance
reviews
Detective
Comparing actual performance
to various benchmarks to identify
unexpected results.
Maintaining
records
Detective
Maintaining written and/or electronic
evidence to support transactions.
Information
systems
security
Preventive/Detective
Using controls such as passwords
and access logs to ensure appropriate
data restrictions.
25
EXHIBIT 1A–1
Types of Internal Controls
for Financial Reporting
by employees in supervisory positions to ensure that actual results are reasonable when
compared to relevant benchmarks. If actual results unexpectedly deviate from expectations, then it triggers further analysis to determine the root cause of the deviation. Companies maintain records to provide evidence that supports each transaction. For example,
companies use serially numbered checks so that they can readily track all of their cash
disbursements. Finally, companies use passwords (a preventive control) and access logs
(a detective control) to restrict electronic data access as appropriate.
It is important to understand that internal controls cannot guarantee that objectives
will be achieved. For example, a person can regularly exercise and eat healthy foods, but
this does not guarantee that they will live to a certain age. Similarly, an effective internal control system can provide reasonable assurance that financial statement disclosures
are reliable, but it cannot offer guarantees because even a well-designed internal control
system can break down. Furthermore, two or more employees may collude to circumvent
the control system. Finally, a company’s senior leaders may manipulate financial results
by intentionally overriding prescribed policies and procedures. This reality highlights the
importance of having senior leaders (including the chief executive officer, the chief financial officer, and the audit committee of the board of directors) who value the importance
of effective internal controls and are committed to creating an ethical “tone at the top” of
the organization.
Glossary
Corporate governance The system by which a company is directed and controlled. (p. 23)
Detective control A control that detects undesirable events that have already occurred. (p. 24)
Internal control A process designed to provide reasonable assurance that objectives are being
achieved. (p. 24)
Preventive control A control that deters undesirable events from occurring. (p. 24)
Sarbanes-Oxley Act of 2002 A law intended to protect the interests of those who invest in publicly traded companies by improving the reliability and accuracy of corporate financial reports
and discloures. (p. 23)
26
Chapter 1
Questions
1A–1 Imagine that you are the head coach of a college sports team. One of your most important objectives is to win as many games as possible. Describe some controls that you
would implement to help achieve the objective of winning as many games as possible.
1A–2 Perhaps your most important post-graduation objective is to get a job. Describe some
control activities that you would pursue to help achieve this objective.
1A–3 Describe some controls that parents use to keep their homes safe for themselves and
their children.
1A–4 Many retail companies experience customer and employee theft (or what is referred to as
shrinkage) that equals 1%–2% of their total sales. For a company such as Walmart, this
seemingly small percentage of total sales translates to billions of dollars. What types of
internal controls might Walmart use to reduce its shrinkage?
1A–5 If you were a restaurant owner, what internal controls would you implement to help
maintain control of your cash?
1A–6 As a form of internal control, what documents would you review prior to paying an
invoice received from a supplier?
1A–7 What internal controls would you implement to help maintain control of your credit
sales and accounts receivable?
1A–8 Why do companies take a physical count of their inventory on hand at least once per year?
1A–9 Why do companies use sequential prenumbering for documents such as checks, sales
invoices, and purchase orders?
1A–10 How can an annual budget function as a form of internal control?
CHAPTER 2
Managerial Accounting
and Cost Concepts
Lowering Healthcare Costs
and Improving Patient Care
LEARNING OBJECTIVES
BUSI N E SS FO C US
After studying Chapter 2, you should be
able to:
Providence Regional Medical Center’s (PRMC) “single stay”
ward is lowering healthcare costs and increasing patient satisfaction. Rather
than transporting post-surgical patients to stationary equipment throughout
the hospital, a “single stay” ward brings all required equipment to stationary
patients. For example, “after heart surgery, cardiac patients remain in one
room throughout their recovery, only the gear and staff are in motion. As
the patient’s condition stabilizes, the beeping machines of intensive care are
removed and physical therapy equipment is added.” The results of this shift
in orientation have been impressive. Patient satisfaction scores have skyrocketed and the average length of a patient’s stay in the hospital has declined by
more than a day. ■
Source: Catherine Arnst, “Radical Surgery,” Bloomberg Businessweek, January 18, 2010,
pp. 40–45.
LO2–1
Understand cost classifications used for
assigning costs to cost objects: direct
costs and indirect costs.
LO2–2
Identify and give examples of each of
the three basic manufacturing cost
categories.
LO2–3
Understand cost classifications used to
prepare financial statements: product
costs and period costs.
LO2–4
Understand cost classifications used to
predict cost behavior: variable costs,
fixed costs, and mixed costs.
LO2–5
Analyze a mixed cost using a scattergraph plot and the high-low method.
LO2–6
Prepare income statements for a
merchandising company using the
traditional and contribution formats.
LO2–7
Understand cost classifications used
in making decisions: differential costs,
opportunity costs, and sunk costs.
LO2–8
(Appendix 2A) Analyze a mixed cost
using a scattergraph plot and the
least-squares regression method.
LO2–9
(Appendix 2B) Identify the four types
of quality costs and explain how they
interact.
LO2–10
(Appendix 2B) Prepare and interpret a
quality cost report.
27
28
Chapter 2
his chapter explains that in managerial accounting the term
cost is used in many different ways. The reason is that there are many types of
costs, and these costs are classified differently according to the immediate needs
of management. For example, managers may want cost data to prepare external
financial reports, to prepare planning budgets, or to make decisions. Each different use
of cost data demands a different classification and definition of costs. For example, the
preparation of external financial reports requires the use of historical cost data, whereas
decision making may require predictions about future costs. This notion of different costs
for different purposes is a critically important aspect of managerial accounting.
Exhibit 2–1 summarizes the cost classifications that will be defined in this chapter,
namely cost classifications (1) for assigning costs to cost objects, (2) for manufacturing
companies, (3) for preparing financial statements, (4) for predicting cost behavior, and
(5) for making decisions. As we begin defining the cost terminology related to each of
these cost classifications, please refer back to this exhibit to help improve your understanding of the overall organization of the chapter.
T
Cost Classifications for Assigning Costs to Cost Objects
LO2–1
Understand cost classifications
used for assigning costs to
cost objects: direct costs and
indirect costs.
Costs are assigned to cost objects for a variety of purposes including pricing, preparing profitability studies, and controlling spending. A cost object is anything for which
cost data are desired—including products, customers, jobs, and organizational subunits.
For purposes of assigning costs to cost objects, costs are classified as either direct or
indirect.
Direct Cost
A direct cost is a cost that can be easily and conveniently traced to a specified cost
object. For example, if Reebok is assigning costs to its various regional and national
sales offices, then the salary of the sales manager in its Tokyo office would be a direct
EXHIBIT 2–1
Summary of Cost Classifications
Purpose of Cost Classification
Cost Classifications
Assigning costs to cost objects
•
•
Direct cost (can be easily traced)
Indirect cost (cannot be easily traced)
Accounting for costs in manufacturing
companies
•
Manufacturing costs
• Direct materials
• Direct labor
• Manufacturing overhead
Nonmanufacturing costs
• Selling costs
• Administrative costs
•
Preparing financial statements
•
•
Product costs (inventoriable)
Period costs (expensed)
Predicting cost behavior in response
to changes in activity
•
•
•
Variable cost (proportional to activity)
Fixed cost (constant in total)
Mixed cost (has variable and fixed elements)
Making decisions
•
•
•
Differential cost (differs between alternatives)
Sunk cost (should be ignored)
Opportunity cost (foregone benefit)
Managerial Accounting and Cost Concepts
29
cost of that office. If a printing company made 10,000 brochures for a specific
customer, then the cost of the paper used to make the brochures would be a direct cost of
that customer.
Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently traced to a specified cost
object. For example, a Campbell Soup factory may produce dozens of varieties of canned
soups. The factory manager’s salary would be an indirect cost of a particular variety such
as chicken noodle soup. The reason is that the factory manager’s salary is incurred as a
consequence of running the entire factory—it is not incurred to produce any one soup
variety. To be traced to a cost object such as a particular product, the cost must be caused
by the cost object. The factory manager’s salary is called a common cost of producing
the various products of the factory. A common cost is a cost that is incurred to support a
number of cost objects but cannot be traced to them individually. A common cost is a type
of indirect cost.
A particular cost may be direct or indirect, depending on the cost object. While the
Campbell Soup factory manager’s salary is an indirect cost of manufacturing chicken
noodle soup, it is a direct cost of the manufacturing division. In the first case, the cost
object is chicken noodle soup. In the second case, the cost object is the entire manufacturing division.
Cost Classifications for Manufacturing Companies
Manufacturing companies such as Texas Instruments, Ford, and DuPont separate their
costs into two broad categories—manufacturing and nonmanufacturing costs.
Manufacturing Costs
Most manufacturing companies further separate their manufacturing costs into two direct
cost categories, direct materials and direct labor, and one indirect cost category, manufacturing overhead. A discussion of each of these categories follows.
Direct Materials The materials that go into the final product are called raw
materials. This term is somewhat misleading because it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials refer to any materials
that are used in the final product; and the finished product of one company can become
the raw materials of another company. For example, the plastics produced by Du Pont
are a raw material used by Hewlett-Packard in its personal computers.
Raw materials may include both direct and indirect materials. Direct materials are
those materials that become an integral part of the finished product and whose costs can
be conveniently traced to the finished product. This would include, for example, the seats
that Airbus purchases from subcontractors to install in its commercial aircraft and the
electronic components that Apple uses in its iPhones.
Sometimes it isn’t worth the effort to trace the costs of relatively insignificant materials to end products. Such minor items would include the solder used to make electrical
connections in a Sony HDTV or the glue used to assemble an Ethan Allen chair. Materials such as solder and glue are called indirect materials and are included as part of
manufacturing overhead, which is discussed shortly.
Direct Labor Direct labor consists of labor costs that can be easily (i.e., physically
and conveniently) traced to individual units of product. Direct labor is sometimes called
touch labor because direct labor workers typically touch the product while it is being
made. Examples of direct labor include assembly-line workers at Toyota, carpenters
LO2–2
Identify and give examples
of each of the three basic
manufacturing cost categories.
30
Chapter 2
IN BUSINESS
FOOD PRICES HIT RECORD HIGHS FOR RESTAURANTS
Direct material costs are critically important to restaurants and fast-food chains. In recent years,
some food costs have spiked to record highs. For example, unexpected freezing temperatures
in the southwestern portion of the United States caused the cost of lettuce to increase 290%.
Similarly, the costs of green peppers, tomatoes, and cucumbers jumped 145%, 85%, and 30%,
respectively. A large chain such as Subway can withstand these price increases better than smaller
competitors because of its buying power and long-term contracts.
Source: Anne VanderMey, “Food For Thought,” Fortune, May 9, 2011, p. 12.
at the home builder KB Home, and electricians who install equipment on aircraft at
Bombardier Learjet.
Labor costs that cannot be physically traced to particular products, or that can be
traced only at great cost and inconvenience, are termed indirect labor. Just like indirect materials, indirect labor is treated as part of manufacturing overhead. Indirect labor
includes the labor costs of janitors, supervisors, materials handlers, and night security
guards. Although the efforts of these workers are essential, it would be either impractical or impossible to accurately trace their costs to specific units of product. Hence, such
labor costs are treated as indirect labor.
Manufacturing Overhead Manufacturing overhead, the third manufacturing
cost category, includes all manufacturing costs except direct materials and direct labor.
Manufacturing overhead includes items such as indirect materials; indirect labor; maintenance and repairs on production equipment; and heat and light, property taxes, depreciation, and insurance on manufacturing facilities. A company also incurs costs for heat
and light, property taxes, insurance, depreciation, and so forth, associated with its selling
and administrative functions, but these costs are not included as part of manufacturing
overhead. Only those costs associated with operating the factory are included in manufacturing overhead.
Various names are used for manufacturing overhead, such as indirect manufacturing
cost, factory overhead, and factory burden. All of these terms are synonyms for manufacturing overhead.
Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories: (1) selling costs and
(2) administrative costs. Selling costs include all costs that are incurred to secure customer orders and get the finished product to the customer. These costs are sometimes
called order-getting and order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods
warehouses. Selling costs can be either direct or indirect costs. For example, the cost of
an advertising campaign dedicated to one specific product is a direct cost of that product,
whereas the salary of a marketing manager who oversees numerous products is an indirect cost with respect to individual products.
Administrative costs include all costs associated with the general management
of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the
organization as a whole. Administrative costs can be either direct or indirect costs.
For example, the salary of an accounting manager in charge of accounts receivable
collections in the East region is a direct cost of that region, whereas the salary of a
Managerial Accounting and Cost Concepts
31
chief financial officer who oversees all of a company’s regions is an indirect cost with
respect to individual regions.
Nonmanufacturing costs are also often called selling, general, and administrative
(SG&A) costs or just selling and administrative costs.
Cost Classifications for Preparing Financial Statements
When preparing a balance sheet and an income statement, companies need to classify
their costs as product costs or period costs. To understand the difference between product costs and period costs, we must first discuss the matching principle from financial
accounting.
Generally, costs are recognized as expenses on the income statement in the period
that benefits from the cost. For example, if a company pays for liability insurance in
advance for two years, the entire amount is not considered an expense of the year in which
the payment is made. Instead, one-half of the cost would be recognized as an expense
each year. The reason is that both years—not just the first year—benefit from the insurance payment. The unexpensed portion of the insurance payment is carried on the balance
sheet as an asset called prepaid insurance.
The matching principle is based on the accrual concept that costs incurred to generate a particular revenue should be recognized as expenses in the same period that the
revenue is recognized. This means that if a cost is incurred to acquire or make something
that will eventually be sold, then the cost should be recognized as an expense only when
the sale takes place—that is, when the benefit occurs. Such costs are called product costs.
Product Costs
For financial accounting purposes, product costs include all costs involved in acquiring
or making a product. In the case of manufactured goods, these costs consist of direct
materials, direct labor, and manufacturing overhead.1 Product costs “attach” to units of
product as the goods are purchased or manufactured, and they remain attached as the
goods go into inventory awaiting sale. Product costs are initially assigned to an inventory
account on the balance sheet. When the goods are sold, the costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales revenue
on the income statement. Because product costs are initially assigned to inventories, they
are also known as inventoriable costs.
We want to emphasize that product costs are not necessarily recorded as expenses
on the income statement in the period in which they are incurred. Rather, as explained
above, they are recorded as expenses in the period in which the related products are sold.
Period Costs
Period costs are all the costs that are not product costs. All selling and administrative
expenses are treated as period costs. For example, sales commissions, advertising, executive salaries, public relations, and the rental costs of administrative offices are all period
costs. Period costs are not included as part of the cost of either purchased or manufactured goods; instead, period costs are expensed on the income statement in the period in
which they are incurred using the usual rules of accrual accounting. Keep in mind that
the period in which a cost is incurred is not necessarily the period in which cash changes
hands. For example, as discussed earlier, the costs of liability insurance are spread across
the periods that benefit from the insurance—regardless of the period in which the insurance premium is paid.
1
For internal management purposes, product costs may exclude some manufacturing costs. For example, see Appendix 3A and the discussion in Chapter 6.
LO2–3
Understand cost classifications
used to prepare financial
statements: product costs
and period costs.
32
Chapter 2
Prime Cost and Conversion Cost
Two more cost categories are often used in discussions of manufacturing costs—prime
cost and conversion cost. Prime cost is the sum of direct materials cost and direct labor
cost. Conversion cost is the sum of direct labor cost and manufacturing overhead cost.
The term conversion cost is used to describe direct labor and manufacturing overhead
because these costs are incurred to convert materials into the finished product.
To improve your understanding of these definitions, consider the following scenario:
A company has reported the following costs and expenses for the most recent month:
Direct materials . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . . . .
Selling expenses . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . .
$69,000
$35,000
$14,000
$29,000
$50,000
These costs and expenses can be categorized in a number of ways, including product
costs, period costs, conversion costs, and prime costs:
Product cost 5 Direct materials 1 Direct labor 1 Manufacturing overhead
5 $69,000 1 $35,000 1 $14,000
5 $118,000
Period cost 5 Selling expenses 1 Administrative expenses
5 $29,000 1 $50,000
5 $79,000
Conversion cost 5 Direct labor 1 Manufacturing overhead
5 $35,000 1 $14,000
5 $49,000
Prime cost 5 Direct materials 1 Direct labor
5 $69,000 1 $35,000
5 $104,000
IN BUSINESS
WALMART LOOKS TO REDUCE ITS SHIPPING COSTS
Walmart hopes to lower its shipping costs, thereby enabling it to reduce its “everyday low prices.”
In years past, suppliers would ship their merchandise to Walmart’s distribution centers, and then
Walmart would use its own fleet of trucks to ship goods from its distribution centers to its retail
store locations. However, now Walmart wants to assume control of transporting merchandise
from its suppliers’ manufacturing facilities to its distribution centers. Walmart believes it can
lower these shipping costs by carrying more merchandise per truck and by taking advantage of
volume purchase price discounts for fuel. In exchange for assuming these shipping responsibilities, Walmart is seeking price reductions from suppliers that it can pass along, at least in part,
to its customers.
Source: Chris Burritt, Carol Wolf, and Matthew Boyle, “Why Wal-Mart Wants to Take the Driver’s Seat,” Bloomberg Businessweek, May 31–June 6, 2010, pp. 17–18.
Managerial Accounting and Cost Concepts
33
Cost Classifications for Predicting Cost Behavior
It is often necessary to predict how a certain cost will behave in response to a change in activity. For example, a manager at Under Armour may want to estimate the impact a 5 percent
increase in sales would have on the company’s total direct materials cost. Cost behavior
refers to how a cost reacts to changes in the level of activity. As the activity level rises and
falls, a particular cost may rise and fall as well—or it may remain constant. For planning
purposes, a manager must be able to anticipate which of these will happen; and if a cost
can be expected to change, the manager must be able to estimate how much it will change.
To help make such distinctions, costs are often categorized as variable, fixed, or mixed. The
relative proportion of each type of cost in an organization is known as its cost structure.
For example, an organization might have many fixed costs but few variable or mixed costs.
Alternatively, it might have many variable costs but few fixed or mixed costs.
LO2–4
Understand cost classifications
used to predict cost behavior:
variable costs, fixed costs, and
mixed costs.
Variable Cost
A variable cost varies, in total, in direct proportion to changes in the level of activity.
Common examples of variable costs include cost of goods sold for a merchandising company, direct materials, direct labor, variable elements of manufacturing overhead, such as
indirect materials, supplies, and power, and variable elements of selling and administrative expenses, such as commissions and shipping costs.2
For a cost to be variable, it must be variable with respect to something. That “something” is its activity base. An activity base is a measure of whatever causes the incurrence
of a variable cost. An activity base is sometimes referred to as a cost driver. Some of the
most common activity bases are direct labor-hours, machine-hours, units produced, and
units sold. Other examples of activity bases (cost drivers) include the number of miles
driven by salespersons, the number of pounds of laundry cleaned by a hotel, the number
of calls handled by technical support staff at a software company, and the number of beds
occupied in a hospital. While there are many activity bases within organizations, throughout this textbook, unless stated otherwise, you should assume that the activity base under
consideration is the total volume of goods and services provided by the organization. We
will specify the activity base only when it is something other than total output.
To provide an example of a variable cost, consider Nooksack Expeditions, a small
company that provides daylong whitewater rafting excursions on rivers in the North
COST DRIVERS IN THE ELECTRONICS INDUSTRY
Accenture Ltd. estimates that the U.S. electronics industry spends $13.8 billion annually to rebox,
restock, and resell returned products. Conventional wisdom is that customers only return products
when they are defective, but the data show that this explanation only accounts for 5% of customer
returns. The biggest cost drivers that cause product returns are that customers often inadvertently
buy the wrong products and that they cannot understand how to use the products that they have
purchased. Television manufacturer Vizio Inc. has started including more information on its packaging to help customers avoid buying the wrong product. Seagate Technologies is replacing thick
instruction manuals with simpler guides that make it easier for customers to begin using their
products.
Source: Christopher Lawton, “The War on Returns,” The Wall Street Journal, May 8, 2008, pp. D1 and D6.
2
Direct labor costs often can be fixed instead of variable for a variety of reasons. For example, in some
countries, such as France, Germany, and Japan, labor regulations and cultural norms may limit management’s ability to adjust the labor force in response to changes in activity. In this textbook, always assume
that direct labor is a variable cost unless you are explicitly told otherwise.
IN BUSINESS
34
Chapter 2
IN BUSINESS
FOOD COSTS AT A LUXURY HOTEL
The Sporthotel Theresa (http://www.theresa.at/), owned and operated by the Egger family, is a four
star hotel located in Zell im Zillertal, Austria. The hotel features access to hiking, skiing, biking, and
other activities in the Ziller alps as well as its own fitness facility and spa.
Three full meals a day are included in the hotel room charge. Breakfast and lunch are served
buffet-style while dinner is a more formal affair with as many as six courses. The chef, Stefan Egger,
believes that food costs are roughly proportional to the number of guests staying at the hotel; that
is, they are a variable cost. He must order food from suppliers two or three days in advance, but
he adjusts his purchases to the number of guests who are currently staying at the hotel and their
consumption patterns. In addition, guests make their selections from the dinner menu early in the
day, which helps Stefan plan which foodstuffs will be required for dinner. Consequently, he is able to
prepare just enough food so that all guests are satisfied and yet waste is held to a minimum.
Source: Conversation with Stefan Egger, chef at the Sporthotel Theresa.
Cascade Mountains. The company provides all of the necessary equipment and experienced guides, and it serves gourmet meals to its guests. The meals are purchased from a
caterer for $30 a person for a daylong excursion. The behavior of this variable cost, on
both a per unit and a total basis, is shown below:
Number
of Guests
250 . . . . . . . . . . . . . . . .
500 . . . . . . . . . . . . . . . .
750 . . . . . . . . . . . . . . . .
1,000 . . . . . . . . . . . . . . . .
Cost of Meals
per Guest
Total Cost
of Meals
$30
$30
$30
$30
$7,500
$15,000
$22,500
$30,000
While total variable costs change as the activity level changes, it is important to note
that a variable cost is constant if expressed on a per unit basis. For example, the per unit
cost of the meals remains constant at $30 even though the total cost of the meals increases
and decreases with activity. The graph on the left-hand side of Exhibit 2–2 illustrates that
the total variable cost rises and falls as the activity level rises and falls. At an activity level
of 250 guests, the total meal cost is $7,500. At an activity level of 1,000 guests, the total
meal cost rises to $30,000.
Fixed Cost
A fixed cost is a cost that remains constant, in total, regardless of changes in the level of
activity. Examples of fixed costs include straight-line depreciation, insurance, property
taxes, rent, supervisory salaries, administrative salaries, and advertising. Unlike variable
costs, fixed costs are not affected by changes in activity. Consequently, as the activity
level rises and falls, total fixed costs remain constant unless influenced by some outside force, such as a landlord increasing your monthly rental expense. To continue the
Nooksack Expeditions example, assume the company rents a building for $500 per
month to store its equipment. The total amount of rent paid is the same regardless of
the number of guests the company takes on its expeditions during any given month. The
concept of a fixed cost is shown graphically on the right-hand side of Exhibit 2–2.
Because total fixed costs remain constant for large variations in the level of activity, the average fixed cost per unit becomes progressively smaller as the level of activity increases. If Nooksack Expeditions has only 250 guests in a month, the $500 fixed
rental cost would amount to an average of $2 per guest. If there are 1,000 guests, the
fixed rental cost would average only 50 cents per guest. The table below illustrates
Managerial Accounting and Cost Concepts
35
EXHIBIT 2–2
Variable and Fixed Cost Behavior
Total Cost of Meals
Total Cost of Renting the Building
$30,000
A variable cost increases,
in total, in proportion
to activity.
Total cost of meals
$25,000
Fixed costs remain
constant in total dollar
amount through
wide ranges of activity.
$20,000
Cost of
building
rental
$15,000
$500
$10,000
$5,000
$0
0
250
500
750
Number of guests
$0
1,000
0
250
500
750
Number of guests
this aspect of the behavior of fixed costs. Note that as the number of guests increase,
the average fixed cost per guest drops.
Monthly
Rental Cost
$500 . . . . . . . . .
$500 . . . . . . . . .
$500 . . . . . . . . .
$500 . . . . . . . . .
Number
of Guests
Average Cost
per Guest
250
500
750
1,000
$2.00
$1.00
$0.67
$0.50
As a general rule, we caution against expressing fixed costs on an average per unit
basis in internal reports because it creates the false impression that fixed costs are like
variable costs and that total fixed costs actually change as the level of activity changes.
For planning purposes, fixed costs can be viewed as either committed or discretionary. Committed fixed costs represent organizational investments with a multiyear planning horizon that can’t be significantly reduced even for short periods of time without
making fundamental changes. Examples include investments in facilities and equipment,
as well as real estate taxes, insurance expenses, and salaries of top management. Even if
operations are interrupted or cut back, committed fixed costs remain largely unchanged
in the short term because the costs of restoring them later are likely to be far greater than
any short-run savings that might be realized. Discretionary fixed costs (often referred
to as managed fixed costs) usually arise from annual decisions by management to spend
on certain fixed cost items. Examples of discretionary fixed costs include advertising,
research, public relations, management development programs, and internships for students. Discretionary fixed costs can be cut for short periods of time with minimal damage
to the long-run goals of the organization.
The Linearity Assumption and the Relevant Range
Management accountants ordinarily assume that costs are strictly linear; that is, the relation between cost on the one hand and activity on the other can be represented by a
straight line. Economists point out that many costs are actually curvilinear; that is, the
relation between cost and activity is a curve. Nevertheless, even if a cost is not strictly
1,000
36
Chapter 2
EXHIBIT 2–3
Fixed Costs and the Relevant
Range
Cost
$60,000
$40,000
$20,000
0
3,000
6,000
Number of Tests
9,000
linear, it can be approximated within a narrow band of activity known as the relevant
range by a straight line. The relevant range is the range of activity within which the
assumption that cost behavior is strictly linear is reasonably valid. Outside of the relevant
range, a fixed cost may no longer be strictly fixed or a variable cost may not be strictly
variable. Managers should always keep in mind that assumptions made about cost behavior may be invalid if activity falls outside of the relevant range.
The concept of the relevant range is important in understanding fixed costs. For
example, suppose the Mayo Clinic rents a machine for $20,000 per month that tests
blood samples for the presence of leukemia cells. Furthermore, suppose that the capacity of the leukemia diagnostic machine is 3,000 tests per month. The assumption that
the rent for the diagnostic machine is $20,000 per month is only valid within the relevant range of 0 to 3,000 tests per month. If the Mayo Clinic needed to test 5,000 blood
samples per month, then it would need to rent another machine for an additional $20,000
per month. It would be difficult to rent half of a diagnostic machine; therefore, the step
pattern depicted in Exhibit 2–3 is typical for such costs. This exhibit shows that the
fixed rental expense is $20,000 for a relevant range of 0 to 3,000 tests. The fixed rental
expense increases to $40,000 within the relevant range of 3,001 to 6,000 tests. The rental
expense increases in discrete steps or increments of 3,000 tests, rather than increasing in
a linear fashion per test.
This step-oriented cost behavior pattern can also be used to describe other costs,
such as some labor costs. For example, salaried employee expenses can be characterized
using a step pattern. Salaried employees are paid a fixed amount, such as $40,000 per
year, for providing the capacity to work a prespecified amount of time, such as 40 hours
per week for 50 weeks a year (5 2,000 hours per year). In this example, the total salaried
employee expense is $40,000 within a relevant range of 0 to 2,000 hours of work. The
total salaried employee expense increases to $80,000 (or two employees) if the organization’s work requirements expand to a relevant range of 2,001 to 4,000 hours of work. Cost
behavior patterns such as salaried employees are often called step-variable costs. Stepvariable costs can often be adjusted quickly as conditions change. Furthermore, the width
of the steps for step-variable costs is generally so narrow that these costs can be treated
essentially as variable costs for most purposes. The width of the steps for fixed costs, on
the other hand, is so wide that these costs should be treated as entirely fixed within the
relevant range.
Exhibit 2–4 summarizes four key concepts related to variable and fixed costs. Study
it carefully before reading further.
Managerial Accounting and Cost Concepts
Behavior of the Cost (within the relevant range)
Cost
Variable cost
Fixed cost
In Total
Total variable cost increases
and decreases in proportion
to changes in the activity level.
Total fixed cost is not affected
by changes in the activity
level within the relevant range.
Per Unit
37
EXHIBIT 2–4
Summary of Variable and Fixed
Cost Behavior
Variable cost per unit
remains constant.
Fixed cost per unit
decreases as the activity
level rises and increases
as the activity level falls.
HOW MANY GUIDES?
Majestic Ocean Kayaking, of Ucluelet, British Columbia, is owned and operated by Tracy Morben-Eeftink. The company offers a number of guided kayaking excursions ranging from threehour tours of the Ucluelet harbor to six-day kayaking and camping trips in Clayoquot Sound.
One of the company’s excursions is a four-day kayaking and camping trip to The Broken Group
Islands in the Pacific Rim National Park. Special regulations apply to trips in the park—including a requirement that one certified guide must be assigned for every five guests or fraction
thereof. For example, a trip with 12 guests must have at least three certified guides. Guides
are not salaried and are paid on a per-day basis. Therefore, the cost to the company of the
guides for a trip is a step-variable cost rather than a fixed cost or a strictly variable cost. One
guide is needed for 1 to 5 guests, two guides for 6 to 10 guests, three guides for 11 to 15
guests, and so on.
Sources: Tracy Morben-Eeftink, owner, Majestic Ocean Kayaking. For more information about the company, see
www.oceankayaking.com.
Mixed Costs
A mixed cost contains both variable and fixed cost elements. Mixed costs are also known
as semivariable costs. To continue the Nooksack Expeditions example, the company
incurs a mixed cost called fees paid to the state. It includes a license fee of $25,000 per
year plus $3 per rafting party paid to the state’s Department of Natural Resources. If the
company runs 1,000 rafting parties this year, then the total fees paid to the state would
be $28,000, made up of $25,000 in fixed cost plus $3,000 in variable cost. Exhibit 2–5
depicts the behavior of this mixed cost.
Even if Nooksack fails to attract any customers, the company will still have to
pay the license fee of $25,000. This is why the cost line in Exhibit 2–5 intersects
the vertical cost axis at the $25,000 point. For each rafting party the company organizes, the total cost of the state fees will increase by $3. Therefore, the total cost line
slopes upward as the variable cost of $3 per party is added to the fixed cost of $25,000
per year.
Because the mixed cost in Exhibit 2–5 is represented by a straight line, the following
equation for a straight line can be used to express the relationship between a mixed cost
and the level of activity:
IN BUSINESS
38
Chapter 2
EXHIBIT 2–5
Mixed Cost Behavior
Cost of state license fees
$30,000
$29,000
Slope = Variable cost per unit of activity
$28,000
$27,000
Variable
cost
element
$26,000
$25,000
Intercept = Total fixed cost
Fixed
cost
element
$0
0
500
1,000
Number of rafting parties
Y 5 a 1 bX
In this equation,
Y 5 The total mixed cost
a 5 The total fixed cost (the vertical intercept of the line)
b 5 The variable cost per unit of activity (the slope of the line)
X 5 The level of activity
Because the variable cost per unit equals the slope of the straight line, the steeper the
slope, the higher the variable cost per unit.
In the case of the state fees paid by Nooksack Expeditions, the equation is written as
follows:
Y 5 $25,000 1 $3.00X
Total
mixed
cost
Total
fixed
cost
Variable
cost per
unit of
activity
Activity
level
This equation makes it easy to calculate the total mixed cost for any level of activity
within the relevant range. For example, suppose that the company expects to organize 800 rafting parties in the next year. The total state fees would be calculated as
follows:
Y 5 $25,000 1 ($3.00 per rafting party 3 800 rafting parties)
5 $27,400
The Analysis of Mixed Costs
Mixed costs are very common. For example, the overall cost of providing X-ray services
to patients at the Harvard Medical School Hospital is a mixed cost. The costs of equipment depreciation and radiologists’ and technicians’ salaries are fixed, but the costs of
X-ray film, power, and supplies are variable. At Southwest Airlines, maintenance costs
Managerial Accounting and Cost Concepts
39
are a mixed cost. The company incurs fixed costs for renting maintenance facilities and
for keeping skilled mechanics on the payroll, but the costs of replacement parts, lubricating oils, tires, and so forth, are variable with respect to how often and how far the company’s aircraft are flown.
The fixed portion of a mixed cost represents the minimum cost of having a service
ready and available for use. The variable portion represents the cost incurred for actual
consumption of the service, thus it varies in proportion to the amount of service actually
consumed.
Managers can use a variety of methods to estimate the fixed and variable components of a mixed cost such as account analysis, the engineering approach, the high-low
method, and least-squares regression analysis. In account analysis, an account is classified as either variable or fixed based on the analyst’s prior knowledge of how the cost in
the account behaves. For example, direct materials would be classified as variable and a
building lease cost would be classified as fixed because of the nature of those costs. The
engineering approach to cost analysis involves a detailed analysis of what cost behavior
should be, based on an industrial engineer’s evaluation of the production methods to be
used, the materials specifications, labor requirements, equipment usage, production efficiency, power consumption, and so on.
The high-low and least-squares regression methods estimate the fixed and variable
elements of a mixed cost by analyzing past records of cost and activity data. We will use
an example from Brentline Hospital to illustrate the high-low method calculations and
to compare the resulting high-low method cost estimates to those obtained using leastsquares regression. Appendix 2A demonstrates how to use Microsoft Excel to perform
least-squares regression computations.
Diagnosing Cost Behavior with a Scattergraph Plot
Assume that Brentline Hospital is interested in predicting future monthly maintenance
costs for budgeting purposes. The senior management team believes that maintenance
cost is a mixed cost and that the variable portion of this cost is driven by the number
of patient-days. Each day a patient is in the hospital counts as one patient-day. The
hospital’s chief financial officer gathered the following data for the most recent sevenmonth period:
Month
January . . . . . .
February . . . . . .
March . . . . . . . .
April . . . . . . . .
May . . . . . . . . .
June . . . . . . . . .
July . . . . . . . . .
Activity Level:
Patient-Days
Maintenance
Cost Incurred
5,600
7,100
5,000
6,500
7,300
8,000
6,200
$7,900
$8,500
$7,400
$8,200
$9,100
$9,800
$7,800
The first step in applying the high-low method or the least-squares regression method
is to diagnose cost behavior with a scattergraph plot. The scattergraph plot of maintenance costs versus patient-days at Brentline Hospital is shown in Exhibit 2–6. Two things
should be noted about this scattergraph:
1. The total maintenance cost, Y, is plotted on the vertical axis. Cost is known as the
dependent variable because the amount of cost incurred during a period depends on
the level of activity for the period. (That is, as the level of activity increases, total cost
will also ordinarily increase.)
LO2–5
Analyze a mixed cost using a
scattergraph plot and the highlow method.
EXHIBIT 2–6
Scattergraph Method of Cost
Analysis
Chapter 2
$12,000
Plotting the Data
Y
$10,000
Maintenance cost
40
$8,000
$6,000
$4,000
$2,000
$0
0
2,000
4,000
6,000
Patient-days
8,000
X
10,000
2. The activity, X (patient-days in this case), is plotted on the horizontal axis. Activity is
known as the independent variable because it causes variations in the cost.
From the scattergraph plot, it is evident that maintenance costs do increase with the number of patient-days in an approximately linear fashion. In other words, the points lie
more or less along a straight line that slopes upward and to the right. Cost behavior is
considered linear whenever a straight line is a reasonable approximation for the relation
between cost and activity.
Plotting the data on a scattergraph is an essential diagnostic step that should be performed before performing the high-low method or least-squares regression calculations.
If the scattergraph plot reveals linear cost behavior, then it makes sense to perform the
high-low or least-squares regression calculations to separate the mixed cost into its variable and fixed components. If the scattergraph plot does not depict linear cost behavior,
then it makes no sense to proceed any further in analyzing the data.
The High-Low Method
Assuming that the scattergraph plot indicates a linear relation between cost and activity,
the fixed and variable cost elements of a mixed cost can be estimated using the high-low
method or the least-squares regression method. The high-low method is based on the
rise-over-run formula for the slope of a straight line. As previously discussed, if the relation between cost and activity can be represented by a straight line, then the slope of the
straight line is equal to the variable cost per unit of activity. Consequently, the following
formula can be used to estimate the variable cost:
Y2 2 Y1
Rise 5 _______
Variable cost 5 Slope of the line 5 ____
Run X2 2 X1
To analyze mixed costs with the high-low method, begin by identifying the period
with the lowest level of activity and the period with the highest level of activity. The
period with the lowest activity is selected as the first point in the above formula and
Managerial Accounting and Cost Concepts
the period with the highest activity is selected as the second point. Consequently, the
formula becomes:
Y22 Y1 Cost at the high activity level 2 Cost at the low activity level
Variable cost 5 _______ 5 _________________________________________________
X2 2 X1
High activity level 2 Low activity level
or
Change in cost
Variable cost 5 _______________
Change in activity
Therefore, when the high-low method is used, the variable cost is estimated by dividing
the difference in cost between the high and low levels of activity by the change in activity
between those two points.
To return to the Brentline Hospital example, using the high-low method, we first
identify the periods with the highest and lowest activity—in this case, June and March.
We then use the activity and cost data from these two periods to estimate the variable cost
component as follows:
High activity level (June) . . . . .
Low activity level (March) . . . .
Change . . . . . . . . . . . . . . . . . .
Patient-Days
Maintenance
Cost Incurred
8,000
5,000
3,000
$9,800
7,400
$2,400
Change in cost
$2,400
Variable cost 5 _______________ 5 _______________ 5 $0.80 per patient-day
Change in activity 3,000 patient-days
Having determined that the variable maintenance cost is 80 cents per patient-day,
we can now determine the amount of fixed cost. This is done by taking the total cost at
either the high or the low activity level and deducting the variable cost element. In the
computation below, total cost at the high activity level is used in computing the fixed
cost element:
Fixed cost element 5 Total cost 2 Variable cost element
5 $9,800 2 ($0.80 per patient-day 3 8,000 patient-days)
5 $3,400
Both the variable and fixed cost elements have now been isolated. The cost of maintenance can be expressed as $3,400 per month plus 80 cents per patient-day or as:
Y 5 $3,400 1 $0.80X
Total
maintenance
cost
Total
patient-days
The data used in this illustration are shown graphically in Exhibit 2–7. Notice that a
straight line has been drawn through the points corresponding to the low and high levels
of activity. In essence, that is what the high-low method does—it draws a straight line
through those two points.
Sometimes the high and low levels of activity don’t coincide with the high and low
amounts of cost. For example, the period that has the highest level of activity may not
41
42
Chapter 2
EXHIBIT 2–7
High-Low Method of Cost
Analysis
Activity Patient- Maintenance
Level
Days
Cost
$12,000
High
Low
Y
Maintenance cost
$10,000
8,000
5,000
$9,800
$7,400
Slope =
Variable cost:
$0.80 per
patient-day
Point relating to the
low activity level
$8,000
Point relating to the
high activity level
$6,000
$4,000
Intercept =
Fixed cost:
$3,400
$2,000
$0
0
2,000
4,000
6,000
Patient-days
8,000
X
10,000
have the highest amount of cost. Nevertheless, the costs at the highest and lowest levels
of activity are always used to analyze a mixed cost under the high-low method. The reason is that the analyst would like to use data that reflect the greatest possible variation
in activity.
The high-low method is very simple to apply, but it suffers from a major (and
sometimes critical) defect—it utilizes only two data points. Generally, two data
points are not enough to produce accurate results. Additionally, the periods with the
highest and lowest activity tend to be unusual. A cost formula that is estimated solely
using data from these unusual periods may misrepresent the true cost behavior during
normal periods. Such a distortion is evident in Exhibit 2–7. The straight line should
probably be shifted down somewhat so that it is closer to more of the data points. For
these reasons, least-squares regression will generally be more accurate than the highlow method.
The Least-Squares Regression Method
The least-squares regression method, unlike the high-low method, uses all of the data
to separate a mixed cost into its fixed and variable components. A regression line of
the form Y 5 a 1 bX is fitted to the data, where a represents the total fixed cost and
b represents the variable cost per unit of activity. The basic idea underlying the leastsquares regression method is illustrated in Exhibit 2–8 using hypothetical data points.
Notice from the exhibit that the deviations from the plotted points to the regression line
are measured vertically on the graph. These vertical deviations are called the regression
errors. There is nothing mysterious about the least-squares regression method. It simply
computes the regression line that minimizes the sum of these squared errors. The formulas that accomplish this are fairly complex and involve numerous calculations, but the
principle is simple.
Managerial Accounting and Cost Concepts
Cost
Y
Actual Y
Estimated Y
43
EXHIBIT 2–8
The Concept of Least-Squares
Regression
Error
Regression line
Y = a + bX
X
Level of activity
Fortunately, computers are adept at carrying out the computations required by the
least-squares regression formulas. The data—the observed values of X and Y—are
entered into the computer, and software does the rest. In the case of the Brentline Hospital maintenance cost data, a statistical software package on a personal computer can
calculate the following least-squares regression estimates of the total fixed cost (a) and
the variable cost per unit of activity (b):
a 5 $3,431
b 5 $0.759
Therefore, using the least-squares regression method, the fixed element of the maintenance cost is $3,431 per month and the variable portion is 75.9 cents per patient-day.
In terms of the linear equation Y 5 a 1 bX, the cost formula can be written as
Y 5 $3,431 1 $0.759X
where activity (X) is expressed in patient-days.
Appendix 2A discusses how to use Microsoft Excel to perform least-squares regression calculations. For now, you only need to understand that least-squares regression analysis generally provides more accurate cost estimates than the high-low method because,
rather than relying on just two data points, it uses all of the data points to fit a line that
minimizes the sum of the squared errors. The table below compares Brentline Hospital’s
cost estimates using the high-low method and the least-squares regression method:
Variable cost estimate per patient-day . . . . . . .
Fixed cost estimate per month . . . . . . . . . . . . . .
High-Low
Method
Least-Squares
Regression
Method
$0.800
$3,400
$0.759
$3,431
When Brentline uses the least-squares regression method to create a straight line that
minimizes the sum of the squared errors, it results in estimated fixed costs that are $31
higher than the amount derived using the high-low method. It also decreases the slope
of the straight line resulting in a lower variable cost estimate of $0.759 per patient-day
rather than $0.80 per patient-day as derived using the high-low method.
44
Chapter 2
IN BUSINESS
THE ZIPCAR COMES TO COLLEGE CAMPUSES
Zipcar is a car sharing service based in Cambridge, Massachusetts. The company serves 13 cities
and 120 university campuses. Members pay a $50 annual fee plus $7 an hour to rent a car. They
can use their iPhones to rent a car, locate it in the nearest Zipcar parking lot, unlock it using an
access code, and drive it off the lot. This mixed cost arrangement is attractive to customers who
need a car infrequently and wish to avoid the large cash outlay that comes with buying or leasing a
vehicle.
Source: Jefferson Graham, “An iPhone Gets Zipcar Drivers on Their Way,” USA Today, September 30,
2009, p. 3B.
Traditional and Contribution Format Income Statements
LO2–6
Prepare income statements
for a merchandising company
using the traditional and
contribution formats.
In this section of the chapter, we discuss how to prepare traditional and contribution format income statements for a merchandising company.3 Merchandising companies do
not manufacture the products that they sell to customers. For example, Lowe’s and
Home Depot are merchandising companies because they buy finished products from
manufacturers and then resell them to end consumers.
The Traditional Format Income Statement
Traditional income statements are prepared primarily for external reporting purposes.
The left-hand side of Exhibit 2–9 shows a traditional income statement format for
merchandising companies. This type of income statement organizes costs into two
categories—cost of goods sold and selling and administrative expenses. Sales minus cost
of goods sold equals the gross margin. The gross margin minus selling and administrative
expenses equals net operating income.
The cost of goods sold reports the product costs attached to the merchandise sold
during the period. The selling and administrative expenses report all period costs that
have been expensed as incurred. The cost of goods sold for a merchandising company
EXHIBIT 2–9
Comparing Traditional and Contribution Format Income Statements for Merchandising Companies (all numbers are given)
Contribution Format
Traditional Format
Sales . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold* . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Selling . . . . . . . . . . . . . . . . . . . . . .
Administrative . . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . . .
$12,000
6,000
6,000
$3,100
1,900
5,000
$ 1,000
Sales . . . . . . . . . . . . . . . . . . . .
Variable expenses:
Cost of goods sold . . . . . . .
Variable selling . . . . . . . . . . .
Variable administrative . . . . .
Contribution margin . . . . . . . . .
Fixed expenses:
Fixed selling . . . . . . . . . . . . .
Fixed administrative . . . . . . .
Net operating income . . . . . . .
$12,000
$6,000
600
400
2,500
1,500
7,000
5,000
4,000
$ 1,000
*For a manufacturing company, the cost of goods sold would include some variable costs, such as direct materials,
direct labor, and variable overhead, and some fixed costs, such as fixed manufacturing overhead. Income statement formats for manufacturing companies will be explored in greater detail in a subsequent chapter.
3
Subsequent chapters compare the income statement formats for manufacturing companies.
Managerial Accounting and Cost Concepts
45
can be computed directly by multiplying the number of units sold by their unit cost or
indirectly using the equation below:
Ending
Beginning
Cost of 5
1 Purchases 2 merchandise
merchandise
goods sold
inventory
inventory
For example, let’s assume that the company depicted in Exhibit 2–9 purchased $3,000
of merchandise inventory during the period and had beginning and ending merchandise
inventory balances of $7,000 and $4,000, respectively. The equation above could be used
to compute the cost of goods sold as follows:
Ending
Beginning
Cost of goods
5 merchandise 1 Purchases 2 merchandise
sold
inventory
inventory
5
$7,000
5
$6,000
1 $3,000 2
$4,000
Although the traditional income statement is useful for external reporting purposes, it has serious limitations when used for internal purposes. It does not distinguish
between fixed and variable costs. For example, under the heading “Selling and administrative expenses,” both variable administrative costs ($400) and fixed administrative costs
($1,500) are lumped together ($1,900). Internally, managers need cost data organized by
cost behavior to aid in planning, controlling, and decision making. The contribution format income statement has been developed in response to these needs.
The Contribution Format Income Statement
The crucial distinction between fixed and variable costs is at the heart of the contribution
approach to constructing income statements. The unique thing about the contribution
approach is that it provides managers with an income statement that clearly distinguishes
between fixed and variable costs and therefore aids planning, controlling, and decision
making. The right-hand side of Exhibit 2–9 shows a contribution format income statement for merchandising companies.
The contribution approach separates costs into fixed and variable categories, first
deducting variable expenses from sales to obtain the contribution margin. For a merchandising company, cost of goods sold is a variable cost that gets included in the “Variable expenses” portion of the contribution format income statement. The contribution
margin is the amount remaining from sales revenues after variable expenses have been
deducted. This amount contributes toward covering fixed expenses and then toward
profits for the period.
The contribution format income statement is used as an internal planning and decision-making tool. Its emphasis on cost behavior aids cost-volume-profit analysis (such as
we shall be doing in a subsequent chapter), management performance appraisals, and
budgeting. Moreover, the contribution approach helps managers organize data pertinent
to numerous decisions such as product-line analysis, pricing, use of scarce resources, and
make or buy analysis. All of these topics are covered in later chapters.
Cost Classifications for Decision Making
Costs are an important feature of many business decisions. In making decisions, it is essential to have a firm grasp of the concepts differential cost, opportunity cost, and sunk cost.
Differential Cost and Revenue
Decisions involve choosing between alternatives. In business decisions, each alternative
will have costs and benefits that must be compared to the costs and benefits of the other
available alternatives. A difference in costs between any two alternatives is known as a
LO2–7
Understand cost classifications
used in making decisions:
differential costs, opportunity
costs, and sunk costs.
46
Chapter 2
differential cost. A difference in revenues (usually just sales) between any two alternatives is known as differential revenue.
A differential cost is also known as an incremental cost, although technically an
incremental cost should refer only to an increase in cost from one alternative to another;
decreases in cost should be referred to as decremental costs. Differential cost is a broader
term, encompassing both cost increases (incremental costs) and cost decreases (decremental costs) between alternatives.
The accountant’s differential cost concept can be compared to the economist’s marginal cost concept. In speaking of changes in cost and revenue, the economist uses the
terms marginal cost and marginal revenue. The revenue that can be obtained from selling
one more unit of product is called marginal revenue, and the cost involved in producing
one more unit of product is called marginal cost. The economist’s marginal concept is basically the same as the accountant’s differential concept applied to a single unit of output.
Differential costs can be either fixed or variable. To illustrate, assume that Natural
Cosmetics, Inc., is thinking about changing its marketing method from distribution through
retailers to distribution by a network of neighborhood sales representatives. Present costs
and revenues are compared to projected costs and revenues in the following table:
Sales (Variable) . . . . . . . . . . . . . . . . . .
Cost of goods sold (Variable) . . . . . . .
Advertising (Fixed) . . . . . . . . . . . . . . . .
Commissions (Variable) . . . . . . . . . . . .
Warehouse depreciation (Fixed) . . . . .
Other expenses (Fixed) . . . . . . . . . . . .
Total expenses . . . . . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . . . .
Retailer
Distribution
(present)
Sales
Representatives
(proposed)
Differential
Costs and
Revenues
$700,000
350,000
80,000
0
50,000
60,000
540,000
$160,000
$800,000
400,000
45,000
40,000
80,000
60,000
625,000
$175,000
$100,000
50,000
(35,000)
40,000
30,000
0
85,000
$ 15,000
According to the above analysis, the differential revenue is $100,000 and the differential
costs total $85,000, leaving a positive differential net operating income of $15,000 in
favor of using sales representatives.
In general, only the differences between alternatives are relevant in decisions. Those
items that are the same under all alternatives and that are not affected by the decision
can be ignored. For example, in the Natural Cosmetics, Inc., example above, the “Other
expenses” category, which is $60,000 under both alternatives, can be ignored because it
has no effect on the decision. If it were removed from the calculations, the sales representatives would still be preferred by $15,000. This is an extremely important principle in
management accounting that we will revisit in later chapters.
Opportunity Cost and Sunk Cost
Opportunity cost is the potential benefit that is given up when one alternative is selected
over another. For example, assume that you have a part-time job while attending college
that pays $200 per week. If you spend one week at the beach during spring break without
pay, then the $200 in lost wages would be an opportunity cost of taking the week off to
be at the beach. Opportunity costs are not usually found in accounting records, but they
are costs that must be explicitly considered in every decision a manager makes. Virtually
every alternative involves an opportunity cost.
A sunk cost is a cost that has already been incurred and that cannot be changed by
any decision made now or in the future. Because sunk costs cannot be changed by any
decision, they are not differential costs. And because only differential costs are relevant in
a decision, sunk costs should always be ignored.
Managerial Accounting and Cost Concepts
47
To illustrate a sunk cost, assume that a company paid $50,000 several years ago for
a special-purpose machine. The machine was used to make a product that is now obsolete and is no longer being sold. Even though in hindsight purchasing the machine may
have been unwise, the $50,000 cost has already been incurred and cannot be undone.
And it would be folly to continue making the obsolete product in a misguided attempt to
“recover” the original cost of the machine. In short, the $50,000 originally paid for the
machine is a sunk cost that should be ignored in current decisions.
THE ECONOMICS OF DRIVING YOUR DREAM CAR
IN BUSINESS
The costs of buying, insuring, repairing, and garaging ultra-luxury vehicles can be very expensive. For example, the purchase price alone for a new Lamborghini or Bentley can easily exceed
$300,000. Thus, Gotham Dream Cars offers an alternative to customers who want to drive ultraluxury cars while avoiding the exorbitant costs of ownership. It sells fractional shares in luxury
cars—the minimum price starts at $9,000 for 20 driving-days. George Johnson is a Gotham Dream
Cars customer who spent $30,000 for 90 driving-days in two types of ultra-luxury vehicles. He
noted that “it’s not worth it to buy one of these cars when you have to fix them.” In essence, Johnson compared the costs of ownership with the rental costs and decided to rent.
Source: David Kiley, “My Lamborghini—Today, Anyway,” BusinessWeek, January 14, 2008, p. 17.
Summary
In this chapter, we have discussed ways in which managers classify costs. How the costs will be
used—for assigning costs to cost objects, preparing external reports, predicting cost behavior, or
decision making—will dictate how the costs are classified.
For purposes of assigning costs to cost objects such as products or departments, costs are classified as direct or indirect. Direct costs can be conveniently traced to cost objects. Indirect costs
cannot be conveniently traced to cost objects.
For external reporting purposes, costs are classified as either product costs or period costs.
Product costs are assigned to inventories and are considered assets until the products are sold. At the
point of sale, product costs become cost of goods sold on the income statement. In contrast, period
costs are taken directly to the income statement as expenses in the period in which they are incurred.
For purposes of predicting how costs will react to changes in activity, costs are classified into
three categories—variable, fixed, and mixed. Variable costs, in total, are strictly proportional to
activity. The variable cost per unit is constant. Fixed costs, in total, remain the same as the activity
level changes within the relevant range. The average fixed cost per unit decreases as the activity
level increases. Mixed costs consist of variable and fixed elements and can be expressed in equation form as Y 5 a 1 bX, where X is the activity, Y is the total cost, a is the fixed cost element, and
b is the variable cost per unit of activity.
If the relation between cost and activity appears to be linear based on a scattergraph plot, then
the variable and fixed components of a mixed cost can be estimated using the high-low method,
which implicitly draws a straight line through the points of lowest activity and highest activity, or
the least-squares regression method, which uses all of the data points to compute a regression line
that minimizes the sum of the squares errors.
The traditional income statement format is used primarily for external reporting purposes. It
organizes costs using product and period cost classifications. The contribution format income statement aids decision making because it organizes costs using variable and fixed cost classifications.
For purposes of making decisions, the concepts of differential cost and revenue, opportunity
cost, and sunk cost are vitally important. Differential costs and revenues are the costs and revenues
that differ between alternatives. Opportunity cost is the benefit that is forgone when one alternative
is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered. Differential costs and opportunity costs should be carefully considered in decisions. Sunk costs are
always irrelevant in decisions and should be ignored.
48
Chapter 2
Review Problem 1: Cost Terms
Many new cost terms have been introduced in this chapter. It will take you some time to learn
what each term means and how to properly classify costs in an organization. Consider the following example: Porter Company manufactures furniture, including tables. Selected costs are
given below:
1. The tables are made of wood that costs $100 per table.
2. The tables are assembled by workers, at a wage cost of $40 per table.
3. Workers assembling the tables are supervised by a factory supervisor who is paid $38,000
per year.
4. Electrical costs are $2 per machine-hour. Four machine-hours are required to produce a table.
5. The depreciation on the machines used to make the tables totals $10,000 per year. The
machines have no resale value and do not wear out through use.
6. The salary of the president of the company is $100,000 per year.
7. The company spends $250,000 per year to advertise its products.
8. Salespersons are paid a commission of $30 for each table sold.
9. Instead of producing the tables, the company could rent its factory space for $50,000 per year.
Required:
Classify these costs according to the various cost terms used in the chapter. Carefully study the
classification of each cost. If you don’t understand why a particular cost is classified the way it is,
reread the section of the chapter discussing the particular cost term. The terms variable cost and
fixed cost refer to how costs behave with respect to the number of tables produced in a year.
Solution to Review Problem 1
Variable
Cost
1. Wood used in a table
($100 per table) . . . . . . . . . . . .
2. Labor cost to assemble
a table ($40 per table) . . . . . . . .
3. Salary of the factory
supervisor ($38,000 per
year) . . . . . . . . . . . . . . . . . . . . .
4. Cost of electricity to
produce tables ($2 per
machine-hour) . . . . . . . . . . . . .
5. Depreciation of machines
used to produce tables
($10,000 per year) . . . . . . . . . . .
6. Salary of the company
president ($100,000 per
year) . . . . . . . . . . . . . . . . . . . . .
7. Advertising expense
($250,000 per
year) . . . . . . . . . . . . . . . . . . . . .
8. Commissions paid
to salespersons
($30 per table sold) . . . . . . . . . .
9. Rental income forgone on
factory space . . . . . . . . . . . . . .
Fixed
Cost
Period
(Selling and
Administrative)
Cost
X
Direct
Materials
Direct
Labor
Manufacturing
Overhead
Sunk
Cost
Opportunity
Cost
X
X
X
X
X
X
X
X
X
Product Cost
X
X
X
X
X
X*
X
X†
*This is a sunk cost because the outlay for the equipment was made in a previous period.
†
This is an opportunity cost because it represents the potential benefit that is lost or sacrificed as a result of using the factory space to produce tables. Opportunity cost is a
special category of cost that is not ordinarily recorded in an organization’s accounting records. To avoid possible confusion with other costs, we will not attempt to classify this
cost in any other way except as an opportunity cost.
Managerial Accounting and Cost Concepts
49
Review Problem 2: High-Low Method
The administrator of Azalea Hills Hospital would like a cost formula linking the administrative
costs involved in admitting patients to the number of patients admitted during a month. The Admitting Department’s costs and the number of patients admitted during the immediately preceding
eight months are given in the following table:
Month
Number of
Patients Admitted
Admitting
Department Costs
1,800
1,900
1,700
1,600
1,500
1,300
1,100
1,500
$14,700
$15,200
$13,700
$14,000
$14,300
$13,100
$12,800
$14,600
May . . . . . . . . . . . . . . . .
June . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . .
September . . . . . . . . . . .
October . . . . . . . . . . . . .
November . . . . . . . . . . .
December . . . . . . . . . . .
Required:
1.
2.
Use the high-low method to estimate the fixed and variable components of admitting costs.
Express the fixed and variable components of admitting costs as a cost formula in the form
Y 5 a 1 bX.
Solution to Review Problem 2
1.
The first step in the high-low method is to identify the periods of the lowest and highest activity. Those periods are November (1,100 patients admitted) and June (1,900 patients admitted).
The second step is to compute the variable cost per unit using those two data points:
Number of
Patients Admitted
Month
Admitting
Department Costs
High activity level (June) . . . . . . . . . . . .
Low activity level (November) . . . . . . . .
1,900
1,100
$15,200
12,800
Change . . . . . . . . . . . . . . . . . . . . . . . . .
800
$ 2,400
Change in cost
$2,400
Variable cost 5 _______________ 5 __________________ 5 $3 per patient admitted
Change in activity 800 patients admitted
The third step is to compute the fixed cost element by deducting the variable cost element
from the total cost at either the high or low activity. In the computation below, the high point
of activity is used:
Fixed cost element 5 Total cost 2 Variable cost element
5 $15,200 2 ($3 per patient admitted 3 1,900 patients admitted)
5 $9,500
2.
The cost formula is Y 5 $9,500 1 $3X.
Glossary
Account analysis A method for analyzing cost behavior in which an account is classified as
either variable or fixed based on the analyst’s prior knowledge of how the cost in the account
behaves. (p. 39)
Activity base A measure of whatever causes the incurrence of a variable cost. For example, the total
cost of X-ray film in a hospital will increase as the number of X-rays taken increases. Therefore,
the number of X-rays is the activity base that explains the total cost of X-ray film. (p. 33)
50
Chapter 2
Administrative costs All executive, organizational, and clerical costs associated with the general
management of an organization rather than with manufacturing or selling. (p. 30)
Committed fixed costs Investments in facilities, equipment, and basic organizational structure
that can’t be significantly reduced even for short periods of time without making fundamental
changes. (p. 35)
Common cost A cost that is incurred to support a number of cost objects but that cannot be traced
to them individually. For example, the wage cost of the pilot of a 747 airliner is a common
cost of all of the passengers on the aircraft. Without the pilot, there would be no flight and no
passengers. But no part of the pilot’s wage is caused by any one passenger taking the flight.
(p. 29)
Contribution approach An income statement format that organizes costs by their behavior. Costs
are separated into variable and fixed categories rather than being separated into product and
period costs for external reporting purposes. (p. 45)
Contribution margin The amount remaining from sales revenues after all variable expenses have
been deducted. (p. 45)
Conversion cost Direct labor cost plus manufacturing overhead cost. (p. 32)
Cost behavior The way in which a cost reacts to changes in the level of activity. (p. 33)
Cost object Anything for which cost data are desired. Examples of cost objects are products, customers, jobs, and parts of the organization such as departments or divisions. (p. 28)
Cost structure The relative proportion of fixed, variable, and mixed costs in an organization.
(p. 33)
Dependent variable A variable that responds to some causal factor; total cost is the dependent
variable, as represented by the letter Y, in the equation Y 5 a 1 bX. (p. 39)
Differential cost A difference in cost between two alternatives. Also see Incremental cost. (p. 46)
Differential revenue The difference in revenue between two alternatives. (p. 46)
Direct cost A cost that can be easily and conveniently traced to a specified cost object. (p. 28)
Direct labor Factory labor costs that can be easily traced to individual units of product. Also
called touch labor. (p. 29)
Direct materials Materials that become an integral part of a finished product and whose costs can
be conveniently traced to it. (p. 29)
Discretionary fixed costs Those fixed costs that arise from annual decisions by management to
spend on certain fixed cost items, such as advertising and research. (p. 35)
Engineering approach A detailed analysis of cost behavior based on an industrial engineer’s
evaluation of the inputs that are required to carry out a particular activity and of the prices of
those inputs. (p. 39)
Fixed cost A cost that remains constant, in total, regardless of changes in the level of activity
within the relevant range. If a fixed cost is expressed on a per unit basis, it varies inversely
with the level of activity. (p. 34)
High-low method A method of separating a mixed cost into its fixed and variable elements by
analyzing the change in cost between the high and low activity levels. (p. 40)
Incremental cost An increase in cost between two alternatives. Also see Differential cost. (p. 46)
Independent variable A variable that acts as a causal factor; activity is the independent variable,
as represented by the letter X, in the equation Y 5 a 1 bX. (p. 40)
Indirect cost A cost that cannot be easily and conveniently traced to a specified cost object.
(p. 29)
Indirect labor The labor costs of janitors, supervisors, materials handlers, and other factory
workers that cannot be conveniently traced to particular products. (p. 30)
Indirect materials Small items of material such as glue and nails that may be an integral part of a
finished product, but whose costs cannot be easily or conveniently traced to it. (p. 29)
Inventoriable costs Synonym for product costs. (p. 31)
Least-squares regression method A method of separating a mixed cost into its fixed and variable elements by fitting a regression line that minimizes the sum of the squared errors. (p. 42)
Linear cost behavior Cost behavior is said to be linear whenever a straight line is a reasonable
approximation for the relation between cost and activity. (p. 40)
Manufacturing overhead All manufacturing costs except direct materials and direct labor.
(p. 30)
Mixed cost A cost that contains both variable and fixed cost elements. (p. 37)
Opportunity cost The potential benefit that is given up when one alternative is selected over
another. (p. 46)
Period costs Costs that are taken directly to the income statement as expenses in the period in
which they are incurred or accrued. (p. 31)
Managerial Accounting and Cost Concepts
51
Prime cost Direct materials cost plus direct labor cost. (p. 32)
Product costs All costs that are involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Also see Inventoriable costs. (p. 31)
Raw materials Any materials that go into the final product. (p. 29)
Relevant range The range of activity within which assumptions about variable and fixed cost
behavior are valid. (p. 36)
Selling costs All costs that are incurred to secure customer orders and get the finished product or
service into the hands of the customer. (p. 30)
Sunk cost A cost that has already been incurred and that cannot be changed by any decision made
now or in the future. (p. 46)
Variable cost A cost that varies, in total, in direct proportion to changes in the level of activity.
A variable cost is constant per unit. (p. 33)
Questions
2–1
2–2
2–3
2–4
2–5
2–6
2–7
2–8
2–9
2–10
2–11
2–12
2–13
2–14
2–15
2–16
2–17
What are the three major elements of product costs in a manufacturing company?
Define the following: (a) direct materials, (b) indirect materials, (c) direct labor, (d) indirect labor, and (e) manufacturing overhead.
Explain the difference between a product cost and a period cost.
Distinguish between (a) a variable cost, (b) a fixed cost, and (c) a mixed cost.
What effect does an increase in volume have on—
a. Unit fixed costs?
b. Unit variable costs?
c. Total fixed costs?
d. Total variable costs?
Define the following terms: (a) cost behavior and (b) relevant range.
What is meant by an activity base when dealing with variable costs? Give several examples of activity bases.
Managers often assume a strictly linear relationship between cost and volume. How can
this practice be defended in light of the fact that many costs are curvilinear?
Distinguish between discretionary fixed costs and committed fixed costs.
Does the concept of the relevant range apply to fixed costs? Explain.
What is the major disadvantage of the high-low method?
Give the general formula for a mixed cost. Which term represents the variable cost? The
fixed cost?
What is meant by the term least-squares regression?
What is the difference between a contribution format income statement and a traditional
format income statement?
What is the contribution margin?
Define the following terms: differential cost, opportunity cost, and sunk cost.
Only variable costs can be differential costs. Do you agree? Explain.
Multiple-choice questions are provided on the text website at www.mhhe.com/garrison15e.
Applying Excel
Available with McGraw-Hill’s Connect® Accounting.
The Excel worksheet form that appears on the next page is to be used to recreate Exhibit 2–9 on
page 44. Download the workbook containing this form from the Online Learning Center at www.
mhhe.com/garrison15e. On the website you will also receive instructions about how to use this
worksheet form.
LO2–6
52
Chapter 2
Required:
1.
2.
Check your worksheet by changing the variable selling cost in the Data area to $900, keeping all of the other data the same as in Exhibit 2–9. If your worksheet is operating properly,
the net operating income under the traditional format income statement and under the
contribution format income statement should now be $700 and the contribution margin
should now be $4,700. If you do not get these answers, find the errors in your worksheet
and correct them.
How much is the gross margin? Did it change? Why or why not?
Suppose that sales are 10% higher as shown below:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable costs:
Cost of goods sold . . . . . . . . . . . . . . . . . . . .
Variable selling . . . . . . . . . . . . . . . . . . . . . . . .
Variable administrative . . . . . . . . . . . . . . . . . .
Fixed costs:
Fixed selling . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed administrative . . . . . . . . . . . . . . . . . . . .
$13,200
$6,600
$990
$440
$2,500
$1,500
Enter this new data into your worksheet. Make sure that you change all of the data that are
different—not just the sales. Print or copy the income statements from your worksheet.
What happened to the variable costs and to the fixed costs when sales increased by 10%?
Why? Did the contribution margin increase by 10%? Why or why not? Did the net operating
income increase by 10%? Why or why not?
Managerial Accounting and Cost Concepts
53
The Foundational 15
Available with McGraw-Hill’s Connect® Accounting.
Martinez Company’s relevant range of production is 7,500 units to 12,500 units. When it produces
and sells 10,000 units, its unit costs are as follows:
LO2–1, LO2–2, LO2–3,
LO2–4, LO2–6, LO2–7
Amount
Per Unit
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . .
Fixed manufacturing overhead . . . . . . . . . . . . . . .
Fixed selling expense . . . . . . . . . . . . . . . . . . . . . .
Fixed administrative expense . . . . . . . . . . . . . . . .
Sales commissions . . . . . . . . . . . . . . . . . . . . . . . .
Variable administrative expense . . . . . . . . . . . . . .
$6.00
$3.50
$1.50
$4.00
$3.00
$2.00
$1.00
$0.50
Required:
1. For financial accounting purposes, what is the total amount of product costs incurred to make
10,000 units?
2. For financial accounting purposes, what is the total amount of period costs incurred to sell
10,000 units?
3. If 8,000 units are sold, what is the variable cost per unit sold?
4. If 12,500 units are sold, what is the variable cost per unit sold?
5. If 8,000 units are sold, what is the total amount of variable costs related to the units sold?
6. If 12,500 units are sold, what is the total amount of variable costs related to the units sold?
7. If 8,000 units are produced, what is the average fixed manufacturing cost per unit
produced?
8. If 12,500 units are produced, what is the average fixed manufacturing cost per unit
produced?
9. If 8,000 units are produced, what is the total amount of fixed manufacturing cost incurred to
support this level of production?
10. If 12,500 units are produced, what is the total amount of fixed manufacturing cost incurred to
support this level of production?
11. If 8,000 units are produced, what is the total amount of manufacturing overhead cost
incurred to support this level of production? What is this total amount expressed on a per
unit basis?
12. If 12,500 units are produced, what is the total amount of manufacturing overhead cost
incurred to support this level of production? What is this total amount expressed on a per
unit basis?
13. If the selling price is $22 per unit, what is the contribution margin per unit sold?
14. If 11,000 units are produced, what are the total amounts of direct and indirect manufacturing
costs incurred to support this level of production?
15. What total incremental cost will Martinez incur if it increases production from 10,000 to
10,001 units?
Exercises
All applicable exercises are available with McGraw-Hill’s Connect® Accounting.
EXERCISE 2–1 Identifying Direct and Indirect Costs [LO2–1]
Northwest Hospital is a full-service hospital that provides everything from major surgery and
emergency room care to outpatient clinics.
Required:
For each cost incurred at Northwest Hospital, indicate whether it would most likely be a direct cost
or an indirect cost of the specified cost object by placing an X in the appropriate column.
54
Chapter 2
Cost
Cost Object
Ex. Catered food served to patients
1. The wages of pediatric nurses
2. Prescription drugs
3. Heating the hospital
4. The salary of the head of pediatrics
5. The salary of the head of pediatrics
6. Hospital chaplain’s salary
7. Lab tests by outside contractor
8. Lab tests by outside contractor
A particular patient
The pediatric department
A particular patient
The pediatric department
The pediatric department
A particular pediatric patient
A particular patient
A particular patient
A particular department
Direct
Cost
Indirect
Cost
X
EXERCISE 2–2 Classifying Manufacturing Costs [LO2–2]
The PC Works assembles custom computers from components supplied by various manufacturers.
The company is very small and its assembly shop and retail sales store are housed in a single facility in a Redmond, Washington, industrial park. Listed below are some of the costs that are incurred
at the company.
Required:
For each cost, indicate whether it would most likely be classified as direct labor, direct materials,
manufacturing overhead, selling, or an administrative cost.
1. The cost of a hard drive installed in a computer.
2. The cost of advertising in the Puget Sound Computer User newspaper.
3. The wages of employees who assemble computers from components.
4. Sales commissions paid to the company’s salespeople.
5. The wages of the assembly shop’s supervisor.
6. The wages of the company’s accountant.
7. Depreciation on equipment used to test assembled computers before release to customers.
8. Rent on the facility in the industrial park.
EXERCISE 2–3 Classification of Costs as Product or Period Cost [LO2–3]
Suppose that you have been given a summer job as an intern at Issac Aircams, a company that manufactures sophisticated spy cameras for remote-controlled military reconnaissance aircraft. The
company, which is privately owned, has approached a bank for a loan to help it finance its growth.
The bank requires financial statements before approving such a loan. You have been asked to help
prepare the financial statements and were given the following list of costs:
1. Depreciation on salespersons’ cars.
2. Rent on equipment used in the factory.
3. Lubricants used for machine maintenance.
4. Salaries of personnel who work in the finished goods warehouse.
5. Soap and paper towels used by factory workers at the end of a shift.
6. Factory supervisors’ salaries.
7. Heat, water, and power consumed in the factory.
8. Materials used for boxing products for shipment overseas. (Units are not normally boxed.)
9. Advertising costs.
10. Workers’ compensation insurance for factory employees.
11. Depreciation on chairs and tables in the factory lunchroom.
12. The wages of the receptionist in the administrative offices.
13. Cost of leasing the corporate jet used by the company’s executives.
14. The cost of renting rooms at a Florida resort for the annual sales conference.
15. The cost of packaging the company’s product.
Required:
Classify the above costs as either product costs or period costs for the purpose of preparing the
financial statements for the bank.
EXERCISE 2–4 Fixed and Variable Cost Behavior [LO2–4]
Espresso Express operates a number of espresso coffee stands in busy suburban malls. The fixed
weekly expense of a coffee stand is $1,200 and the variable cost per cup of coffee served is $0.22.
Managerial Accounting and Cost Concepts
Required:
1.
Fill in the following table with your estimates of total costs and cost per cup of coffee at the
indicated levels of activity for a coffee stand. Round off the cost of a cup of coffee to the nearest tenth of a cent.
Cups of Coffee Served in a Week
Fixed cost . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable cost . . . . . . . . . . . . . . . . . . . . . . . . .
Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Average cost per cup of coffee served . . . . .
2.
2,000
2,100
2,200
?
?
?
?
?
?
?
?
?
?
?
?
Does the average cost per cup of coffee served increase, decrease, or remain the same as the
number of cups of coffee served in a week increases? Explain.
EXERCISE 2–5 High-Low Method [LO2–5]
The Cheyenne Hotel in Big Sky, Montana, has accumulated records of the total electrical costs
of the hotel and the number of occupancy-days over the last year. An occupancy-day represents a
room rented out for one day. The hotel’s business is highly seasonal, with peaks occurring during
the ski season and in the summer.
Month
January . . . . . . . .
February . . . . . . .
March . . . . . . . . .
April . . . . . . . . . .
May . . . . . . . . . . .
June . . . . . . . . . .
July . . . . . . . . . . .
August . . . . . . . .
September . . . . .
October . . . . . . .
November . . . . . .
December . . . . . .
Occupancy-Days
Electrical Costs
1,736
1,904
2,356
960
360
744
2,108
2,406
840
124
720
1,364
$4,127
$4,207
$5,083
$2,857
$1,871
$2,696
$4,670
$5,148
$2,691
$1,588
$2,454
$3,529
Required:
1.
2.
Using the high-low method, estimate the fixed cost of electricity per month and the variable
cost of electricity per occupancy-day. Round off the fixed cost to the nearest whole dollar and
the variable cost to the nearest whole cent.
What other factors other than occupancy-days are likely to affect the variation in electrical
costs from month to month?
EXERCISE 2–6 Traditional and Contribution Format Income Statements [LO2–6]
Cherokee Inc. is a merchandiser that provided the following information:
Amount
Number of units sold . . . . . . . . . . . . . . . . . . . . . . . .
20,000
Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . .
$30
Variable selling expense per unit . . . . . . . . . . . . . . .
$4
Variable administrative expense per unit . . . . . . . . .
$2
Total fixed selling expense . . . . . . . . . . . . . . . . . . . $40,000
Total fixed administrative expense . . . . . . . . . . . . . $30,000
Beginning merchandise inventory . . . . . . . . . . . . . . $24,000
Ending merchandise inventory . . . . . . . . . . . . . . . . $44,000
Merchandise purchases . . . . . . . . . . . . . . . . . . . . . $180,000
55
56
Chapter 2
Required:
1.
2.
Prepare a traditional income statement.
Prepare a contribution format income statement.
EXERCISE 2–7 Differential, Opportunity, and Sunk Costs [LO2–7]
Northwest Hospital is a full-service hospital that provides everything from major surgery and
emergency room care to outpatient clinics. The hospital’s Radiology Department is considering replacing an old inefficient X-ray machine with a state-of-the-art digital X-ray machine. The
new machine would provide higher quality X-rays in less time and at a lower cost per X-ray. It
would also require less power and would use a color laser printer to produce easily readable X-ray
images. Instead of investing the funds in the new X-ray machine, the Laboratory Department is
lobbying the hospital’s management to buy a new DNA analyzer.
Required:
For each of the items below, indicate by placing an X in the appropriate column whether it should
be considered a differential cost, an opportunity cost, or a sunk cost in the decision to replace the
old X-ray machine with a new machine. If none of the categories apply for a particular item, leave
all columns blank.
Differential
Cost
Item
Ex. Cost of X-ray film used in the old machine
1. Cost of the old X-ray machine . . . . . . . . . . . . . . . . . . . . . .
2. The salary of the head of the Radiology Department . . . .
3. The salary of the head of the Pediatrics Department . . . .
4. Cost of the new color laser printer . . . . . . . . . . . . . . . . . .
5. Rent on the space occupied by Radiology . . . . . . . . . . .
6. The cost of maintaining the old machine . . . . . . . . . . . . .
7. Benefits from a new DNA analyzer . . . . . . . . . . . . . . . . . .
8. Cost of electricity to run the X-ray machines . . . . . . . . . .
Opportunity
Cost
Sunk
Cost
X
EXERCISE 2–8 Cost Behavior; High-Low Method [LO2–4, LO2–5]
Hoi Chong Transport, Ltd., operates a fleet of delivery trucks in Singapore. The company has
determined that if a truck is driven 105,000 kilometers during a year, the average operating cost
is 11.4 cents per kilometer. If a truck is driven only 70,000 kilometers during a year, the average
operating cost increases to 13.4 cents per kilometer.
Required:
1.
2.
3.
Using the high-low method, estimate the variable and fixed cost elements of the annual cost of
the truck operation.
Express the variable and fixed costs in the form Y 5 a 1 bX.
If a truck were driven 80,000 kilometers during a year, what total cost would you expect to be
incurred?
EXERCISE 2–9 Cost Terminology for Manufacturers [LO2–2, LO2–3]
Arden Company reported the following costs and expenses for the most recent month:
Direct materials . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . . . . .
Selling expenses . . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . . .
$80,000
$42,000
$19,000
$22,000
$35,000
Required:
1.
2.
3.
4.
What is the total amount of product costs?
What is the total amount of period costs?
What is the total amount of conversion costs?
What is the total amount of prime costs?
EXERCISE 2–10 Cost Behavior; Contribution Format Income Statement [LO2–4, LO2–6]
Harris Company manufactures and sells a single product. A partially completed schedule of the
company’s total and per unit costs over the relevant range of 30,000 to 50,000 units produced and
sold annually is given below:
Managerial Accounting and Cost Concepts
Units Produced and Sold
30,000
40,000
50,000
Total costs:
Variable costs . . . . .
Fixed costs . . . . . . .
$180,000
300,000
?
?
?
?
Total costs . . . . . . . . . .
$480,000
?
?
Cost per unit:
Variable cost . . . . . .
Fixed cost . . . . . . . .
?
?
?
?
?
?
Total cost per unit . . . .
?
?
?
Required:
1.
2.
Complete the schedule of the company’s total and unit costs above.
Assume that the company produces and sells 45,000 units during the year at a selling price of
$16 per unit. Prepare a contribution format income statement for the year.
EXERCISE 2–11 High-Low Method; Scattergraph Analysis [LO2–4, LO2–5]
The following data relating to units shipped and total shipping expense have been assembled by
Archer Company, a wholesaler of large, custom-built air-conditioning units for commercial buildings:
Month
January . . . . . . . . .
February . . . . . . . .
March . . . . . . . . . .
April . . . . . . . . . . .
May . . . . . . . . . . . .
June . . . . . . . . . . . .
July . . . . . . . . . . . .
Units
Shipped
Total Shipping
Expense
3
6
4
5
7
8
2
$1,800
$2,300
$1,700
$2,000
$2,300
$2,700
$1,200
Required:
1.
2.
3.
4.
Prepare a scattergraph using the data given above. Plot cost on the vertical axis and activity
on the horizontal axis. Is there an approximately linear relationship between shipping expense
and the number of units shipped?
Using the high-low method, estimate the cost formula for shipping expense. Draw a straight
line through the high and low data points shown in the scattergraph that you prepared in
requirement 1. Make sure your line intersects the Y axis.
Comment on the accuracy of your high-low estimates assuming a least-squares regression
analysis estimated the total fixed costs to be $910.71 per month and the variable cost to be
$217.86 per unit. How would the straight line that you drew in requirement 2 differ from a
straight line that minimizes the sum of the squared errors?
What factors, other than the number of units shipped, are likely to affect the company’s shipping expense? Explain.
EXERCISE 2–12 Cost Classification [LO2–2, LO2–3, LO2–4, LO2–7]
Wollogong Group Ltd. of New South Wales, Australia, acquired its factory building about 10 years
ago. For several years, the company has rented out a small annex attached to the rear of the building. The company has received a rental income of $30,000 per year on this space. The renter’s
lease will expire soon, and rather than renewing the lease, the company has decided to use the
space itself to manufacture a new product.
Direct materials cost for the new product will total $80 per unit. To have a place to store
finished units of product, the company will rent a small warehouse nearby. The rental cost will
be $500 per month. In addition, the company must rent equipment for use in producing the new
product; the rental cost will be $4,000 per month. Workers will be hired to manufacture the new
product, with direct labor cost amounting to $60 per unit. The space in the annex will continue to
be depreciated on a straight-line basis, as in prior years. This depreciation is $8,000 per year.
Advertising costs for the new product will total $50,000 per year. A supervisor will be hired to
oversee production; her salary will be $1,500 per month. Electricity for operating machines will be
$1.20 per unit. Costs of shipping the new product to customers will be $9 per unit.
57
58
Chapter 2
To provide funds to purchase materials, meet payrolls, and so forth, the company will have to
liquidate some temporary investments. These investments are presently yielding a return of about
$3,000 per year.
Required:
Prepare an answer sheet with the following column headings:
Period
Product Cost
Name
(Selling and
of the Variable Fixed Direct
Direct Manufacturing Administrative) Opportunity Sunk
Cost
Cost
Cost Materials Labor
Overhead
Cost
Cost
Cost
List the different costs associated with the new product decision down the extreme left column (under Name of the Cost). Then place an X under each heading that helps to describe the type
of cost involved. There may be X’s under several column headings for a single cost. (For example,
a cost may be a fixed cost, a period cost, and a sunk cost; you would place an X under each of these
column headings opposite the cost.)
EXERCISE 2–13 Traditional and Contribution Format Income Statements [LO2–6]
The Alpine House, Inc., is a large retailer of snow skis. The company assembled the information
shown below for the quarter ended March 31:
Amount
Total sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling price per pair of skis . . . . . . . . . . . . . . . . . . . . . . .
Variable selling expense per pair of skis . . . . . . . . . . . . .
Variable administrative expense per pair of skis . . . . . . .
Total fixed selling expense . . . . . . . . . . . . . . . . . . . . . . . .
Total fixed administrative expense . . . . . . . . . . . . . . . . . .
Beginning merchandise inventory . . . . . . . . . . . . . . . . . .
Ending merchandise inventory . . . . . . . . . . . . . . . . . . . . .
Merchandise purchases . . . . . . . . . . . . . . . . . . . . . . . . . .
$150,000
$750
$50
$10
$20,000
$20,000
$30,000
$40,000
$100,000
Required:
1.
2.
3.
Prepare a traditional income statement for the quarter ended March 31.
Prepare a contribution format income statement for the quarter ended March 31.
What was the contribution toward fixed expenses and profits for each pair of skis sold during
the quarter? (State this figure in a single dollar amount per pair of skis.)
EXERCISE 2–14 High-Low Method; Predicting Cost [LO2–4, LO2–5]
The Lakeshore Hotel’s guest-days of occupancy and custodial supplies expense over the last seven
months were:
Month
March . . . . . . . . . . . . . . . . . . . . .
April . . . . . . . . . . . . . . . . . . . . . . .
May . . . . . . . . . . . . . . . . . . . . . . .
June . . . . . . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . . . . . . . . . .
September . . . . . . . . . . . . . . . . . .
Guest-Days
of Occupancy
Custodial
Supplies Expense
4,000
6,500
8,000
10,500
12,000
9,000
7,500
$7,500
$8,250
$10,500
$12,000
$13,500
$10,750
$9,750
Guest-days is a measure of the overall activity at the hotel. For example, a guest who stays at
the hotel for three days is counted as three guest-days.
Required:
1.
2.
3.
Using the high-low method, estimate a cost formula for custodial supplies expense.
Using the cost formula you derived above, what amount of custodial supplies expense would
you expect to be incurred at an occupancy level of 11,000 guest-days?
Prepare a scattergraph using the data given above. Plot custodial supplies expense on the vertical axis and the number of guest-days occupied on the horizontal axis. Draw a straight line
Managerial Accounting and Cost Concepts
4.
5.
59
through the two data points that correspond to the high and low levels of activity. Make sure
your line intersects the Y-axis.
Comment on the accuracy of your high-low estimates assuming a least-squares regression
analysis estimated the total fixed costs to be $3,973.10 per month and the variable cost to be
$0.77 per guest-day. How would the straight line that you drew in requirement 3 differ from a
straight line that minimizes the sum of the squared errors?
Using the least-squares regression estimates given in requirement 4, what custodial supplies
expense would you expect to be incurred at an occupancy level of 11,000 guest-days?
EXERCISE 2–15 Classification of Costs as Variable or Fixed and as Product or Period [LO2–3, LO2–4]
Below are listed various costs that are found in organizations.
1. Hamburger buns in a Wendy’s outlet.
2. Advertising by a dental office.
3. Apples processed and canned by Del Monte.
4. Shipping canned apples from a Del Monte plant to customers.
5. Insurance on a Bausch & Lomb factory producing contact lenses.
6. Insurance on IBM’s corporate headquarters.
7. Salary of a supervisor overseeing production of printers at Hewlett-Packard.
8. Commissions paid to automobile salespersons.
9. Depreciation of factory lunchroom facilities at a General Electric plant.
10. Steering wheels installed in BMWs.
Required:
Classify each cost as being either variable or fixed with respect to the number of units produced
and sold. Also classify each cost as either a selling and administrative cost or a product cost. Prepare your answer sheet as shown below. Place an X in the appropriate columns to show the proper
classification of each cost.
Period
(Selling and
Administrative)
Cost
Cost Behavior
Cost Item
Variable
Fixed
Product
Cost
Problems
All applicable problems are available with McGraw-Hill’s Connect® Accounting.
PROBLEM 2–16 Cost Behavior; High-Low Method; Contribution Format Income Statement [LO2–4,
LO2–5, LO2–6]
Morrisey & Brown, Ltd., of Sydney is a merchandising company that is the sole distributor of a
product that is increasing in popularity among Australian consumers. The company’s income statements for the three most recent months follow:
Morrisey & Brown, Ltd.
Income Statements
For the Three Months Ended September 30
July
August
September
Sales in units . . . . . . . . . . . . . . . . . . . . . . . . . .
4,000
4,500
5,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . .
$400,000
240,000
$450,000
270,000
$500,000
300,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . .
160,000
180,000
200,000
Selling and administrative expenses:
Advertising expense . . . . . . . . . . . . . . . . . . .
Shipping expense . . . . . . . . . . . . . . . . . . . . .
Salaries and commissions . . . . . . . . . . . . . .
Insurance expense . . . . . . . . . . . . . . . . . . . .
Depreciation expense . . . . . . . . . . . . . . . . . .
21,000
34,000
78,000
6,000
15,000
21,000
36,000
84,000
6,000
15,000
21,000
38,000
90,000
6,000
15,000
Total selling and administrative expenses
Net operating income . . . . . . . . . . . . . . . . . . . .
154,000
$
6,000
162,000
170,000
$ 18,000
$ 30,000
60
Chapter 2
Required:
1.
2.
3.
Identify each of the company’s expenses (including cost of goods sold) as either variable,
fixed, or mixed.
Using the high-low method, separate each mixed expense into variable and fixed elements.
State the cost formula for each mixed expense.
Redo the company’s income statement at the 5,000-unit level of activity using the contribution
format.
PROBLEM 2–17 High-Low Method; Predicting Cost [LO2–4, LO2–5]
Sawaya Co., Ltd., of Japan is a manufacturing company whose total factory overhead costs fluctuate considerably from year to year according to increases and decreases in the number of direct
labor-hours worked in the factory. Total factory overhead costs at high and low levels of activity for
recent years are given below:
Level of Activity
Direct labor-hours . . . . . . . . . . . . . . . .
Total factory overhead costs . . . . . . . .
Low
High
50,000
$14,250,000
75,000
$17,625,000
The factory overhead costs above consist of indirect materials, rent, and maintenance. The company has analyzed these costs at the 50,000-hour level of activity as follows:
Indirect materials (variable) . . . . . . . . . . . . . . . . . . . . . . .
Rent (fixed) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Maintenance (mixed) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 5,000,000
6,000,000
3,250,000
Total factory overhead costs . . . . . . . . . . . . . . . . . . . . . .
$14,250,000
To have data available for planning, the company wants to break down the maintenance cost into
its variable and fixed cost elements.
Required:
1.
2.
3.
Estimate how much of the $17,625,000 factory overhead cost at the high level of activity consists of maintenance cost. (Hint: To do this, it may be helpful to first determine how much of
the $17,625,000 consists of indirect materials and rent. Think about the behavior of variable
and fixed costs!)
Using the high-low method, estimate a cost formula for maintenance.
What total factory overhead costs would you expect the company to incur at an operating level
of 70,000 direct labor-hours?
PROBLEM 2–18 Variable and Fixed Costs; Subtleties of Direct and Indirect Costs [LO2–1, LO2–4]
Madison Seniors Care Center is a nonprofit organization that provides a variety of health services
to the elderly. The center is organized into a number of departments, one of which is the Meals-OnWheels program that delivers hot meals to seniors in their homes on a daily basis. Below are listed
a number of costs of the center and the Meals-On-Wheels program.
example The cost of groceries used in meal preparation.
a. The cost of leasing the Meals-On-Wheels van.
b. The cost of incidental supplies such as salt, pepper, napkins, and so on.
c. The cost of gasoline consumed by the Meals-On-Wheels van.
d. The rent on the facility that houses Madison Seniors Care Center, including the
Meals-On-Wheels program.
e. The salary of the part-time manager of the Meals-On-Wheels program.
f. Depreciation on the kitchen equipment used in the Meals-On-Wheels program.
g. The hourly wages of the caregiver who drives the van and delivers the meals.
h. The costs of complying with health safety regulations in the kitchen.
i. The costs of mailing letters soliciting donations to the Meals-On-Wheels program.
Required:
For each cost listed above, indicate whether it is a direct or indirect cost of the Meals-On-Wheels
program, whether it is a direct or indirect cost of particular seniors served by the program, and
Managerial Accounting and Cost Concepts
whether it is variable or fixed with respect to the number of seniors served. Use the form below for
your answer.
Item
Description
Example
The cost of
groceries
used in meal
preparation . . .
Direct or Indirect
Cost of the Mealson-Wheels Program
Direct or Indirect
Variable or Fixed
Cost of Particular with Respect to the
Seniors Served
Number of Seniors
by the Meals-on- Served by the MealsWheels Program
on-Wheels Program
Direct
Direct
Indirect
X
Indirect
Variable
X
Fixed
X
PROBLEM 2–19 Contribution Format versus Traditional Income Statement [LO2–6]
Marwick’s Pianos, Inc., purchases pianos from a large manufacturer and sells them at the retail
level. The pianos cost, on the average, $2,450 each from the manufacturer. Marwick’s Pianos, Inc.,
sells the pianos to its customers at an average price of $3,125 each. The selling and administrative
costs that the company incurs in a typical month are presented below:
Costs
Cost Formula
Selling:
Advertising . . . . . . . . . . . . . . . . . . . . . . .
Sales salaries and commissions . . . . . .
Delivery of pianos to customers . . . . . .
Utilities . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation of sales facilities . . . . . . . .
Administrative:
Executive salaries . . . . . . . . . . . . . . . . .
Insurance . . . . . . . . . . . . . . . . . . . . . . . .
Clerical . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation of office equipment . . . . . .
$700 per month
$950 per month, plus 8% of sales
$30 per piano sold
$350 per month
$800 per month
$2,500 per month
$400 per month
$1,000 per month, plus $20 per piano sold
$300 per month
During August, Marwick’s Pianos, Inc., sold and delivered 40 pianos.
Required:
1.
2.
3.
Prepare an income statement for Marwick’s Pianos, Inc., for August. Use the traditional format, with costs organized by function.
Redo (1) above, this time using the contribution format, with costs organized by behavior.
Show costs and revenues on both a total and a per unit basis down through contribution
margin.
Refer to the income statement you prepared in (2) above. Why might it be misleading to show
the fixed costs on a per unit basis?
PROBLEM 2–20 High-Low Method; Predicting Cost [LO2–4, LO2–5]
Nova Company’s total overhead cost at various levels of activity are presented below:
Month
April . . . . . . . . . . . . .
May . . . . . . . . . . . . . .
June . . . . . . . . . . . . . .
July . . . . . . . . . . . . . .
MachineHours
Total
Overhead
Cost
70,000
60,000
80,000
90,000
$198,000
$174,000
$222,000
$246,000
61
62
Chapter 2
Assume that the total overhead cost above consists of utilities, supervisory salaries, and maintenance. The breakdown of these costs at the 60,000 machine-hour level of activity is:
Utilities (variable) . . . . . . . . . . .
Supervisory salaries (fixed) . . .
Maintenance (mixed) . . . . . . . .
$ 48,000
21,000
105,000
Total overhead cost . . . . . . . . .
$174,000
Nova Company’s management wants to break down the maintenance cost into its variable and
fixed cost elements.
Required:
1.
2.
3.
4.
Estimate how much of the $246,000 of overhead cost in July was maintenance cost. (Hint: to
do this, it may be helpful to first determine how much of the $246,000 consisted of utilities
and supervisory salaries. Think about the behavior of variable and fixed costs!)
Using the high-low method, estimate a cost formula for maintenance.
Express the company’s total overhead cost in the linear equation form Y 5 a 1 bX.
What total overhead cost would you expect to be incurred at an activity level of 75,000
machine-hours?
PROBLEM 2–21 Cost Classification [LO2–1, LO2–3, LO2–4]
Listed below are costs found in various organizations.
1. Property taxes, factory.
2. Boxes used for packaging detergent produced by the company.
3. Salespersons’ commissions.
4. Supervisor’s salary, factory.
5. Depreciation, executive autos.
6. Wages of workers assembling computers.
7. Insurance, finished goods warehouses.
8. Lubricants for production equipment.
9. Advertising costs.
10. Microchips used in producing calculators.
11. Shipping costs on merchandise sold.
12. Magazine subscriptions, factory lunchroom.
13. Thread in a garment factory.
14. Billing costs.
15. Executive life insurance.
16. Ink used in textbook production.
17. Fringe benefits, assembly-line workers.
18. Yarn used in sweater production.
19. Wages of receptionist, executive offices.
Required:
Prepare an answer sheet with column headings as shown below. For each cost item, indicate
whether it would be variable or fixed with respect to the number of units produced and sold;
and then whether it would be a selling cost, an administrative cost, or a manufacturing cost.
If it is a manufacturing cost, indicate whether it would typically be treated as a direct cost
or an indirect cost with respect to units of product. Three sample answers are provided for
illustration.
Cost Item
Direct labor . . . . . . . . . . . . . . .
Executive salaries . . . . . . . . . .
Factory rent . . . . . . . . . . . . . . .
Variable
or Fixed
V
F
F
Selling
Cost
Administrative
Cost
Manufacturing
(Product) Cost
Direct
Indirect
X
X
X
Managerial Accounting and Cost Concepts
PROBLEM 2–22 High-Low and Scattergraph Analysis [LO2–4, LO2–5]
Pleasant View Hospital of British Columbia has just hired a new chief administrator who is anxious to employ sound management and planning techniques in the business affairs of the hospital.
Accordingly, she has directed her assistant to summarize the cost structure of the various departments so that data will be available for planning purposes.
The assistant is unsure how to classify the utilities costs in the Radiology Department
because these costs do not exhibit either strictly variable or fixed cost behavior. Utilities costs are
very high in the department due to a CAT scanner that draws a large amount of power and is kept
running at all times. The scanner can’t be turned off due to the long warm-up period required for
its use. When the scanner is used to scan a patient, it consumes an additional burst of power. The
assistant has accumulated the following data on utilities costs and use of the scanner since the
first of the year.
Month
January . . . . . . . . . . . . . . . . . . .
February . . . . . . . . . . . . . . . . . .
March . . . . . . . . . . . . . . . . . . . .
April . . . . . . . . . . . . . . . . . . . . .
May . . . . . . . . . . . . . . . . . . . . . .
June . . . . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . . . . . . . .
September . . . . . . . . . . . . . . . .
October . . . . . . . . . . . . . . . . . .
Number
of Scans
Utilities
Cost
60
70
90
120
100
130
150
140
110
80
$2,200
$2,600
$2,900
$3,300
$3,000
$3,600
$4,000
$3,600
$3,100
$2,500
The chief administrator has informed her assistant that the utilities cost is probably a mixed
cost that will have to be broken down into its variable and fixed cost elements by use of a scattergraph. The assistant feels, however, that if an analysis of this type is necessary, then the high-low
method should be used, since it is easier and quicker. The controller has suggested that there may
be a better approach.
Required:
1.
2.
3.
Using the high-low method, estimate a cost formula for utilities. Express the formula in the
form Y 5 a 1 bX. (The variable rate should be stated in terms of cost per scan.)
Prepare a scattergraph by plotting the number of scans and utility cost on a graph. Draw a
straight line though the two data points that correspond to the high and low levels of activity.
Make sure your line intersects the Y-axis.
Comment on the accuracy of your high-low estimates assuming a least-squares regression
analysis estimated the total fixed costs to be $1,170.90 per month and the variable cost to be
$18.18 per scan. How would the straight line that you drew in requirement 2 differ from a
straight line that minimizes the sum of the squared errors?
PROBLEM 2–23 High-Low Method; Contribution Format Income Statement [LO2–5, LO2–6]
Milden Company has an exclusive franchise to purchase a product from the manufacturer and
distribute it on the retail level. As an aid in planning, the company has decided to start using a
contribution format income statement. To have data to prepare such a statement, the company has
analyzed its expenses and has developed the following cost formulas:
Cost
Cost Formula
Cost of good sold . . . . . . . . . . . .
Advertising expense . . . . . . . . . .
Sales commissions . . . . . . . . . . .
Shipping expense . . . . . . . . . . . .
Administrative salaries . . . . . . . .
Insurance expense . . . . . . . . . . .
Depreciation expense . . . . . . . . .
$35 per unit sold
$210,000 per quarter
6% of sales
?
$145,000 per quarter
$9,000 per quarter
$76,000 per quarter
63
64
Chapter 2
Management has concluded that shipping expense is a mixed cost, containing both variable and
fixed cost elements. Units sold and the related shipping expense over the last eight quarters follow:
Quarter
Year 1:
First . . . . . . . . . . . . . . . . . . . . . .
Second . . . . . . . . . . . . . . . . . . .
Third . . . . . . . . . . . . . . . . . . . . .
Fourth . . . . . . . . . . . . . . . . . . . .
Year 2:
First . . . . . . . . . . . . . . . . . . . . . .
Second . . . . . . . . . . . . . . . . . . .
Third . . . . . . . . . . . . . . . . . . . . .
Fourth . . . . . . . . . . . . . . . . . . . .
Units Sold
Shipping
Expense
10,000
16,000
18,000
15,000
$119,000
$175,000
$190,000
$164,000
11,000
17,000
20,000
13,000
$130,000
$185,000
$210,000
$147,000
Milden Company’s president would like a cost formula derived for shipping expense so that a
budgeted contribution format income statement can be prepared for the next quarter.
Required:
1.
2.
Using the high-low method, estimate a cost formula for shipping expense.
In the first quarter of Year 3, the company plans to sell 12,000 units at a selling price of $100
per unit. Prepare a contribution format income statement for the quarter.
PROBLEM 2–24 Ethics and the Manager [LO2–3]
M. K. Gallant is president of Kranbrack Corporation, a company whose stock is traded on a national
exchange. In a meeting with investment analysts at the beginning of the year, Gallant had predicted
that the company’s earnings would grow by 20% this year. Unfortunately, sales have been less than
expected for the year, and Gallant concluded within two weeks of the end of the fiscal year that it
would be impossible to ultimately report an increase in earnings as large as predicted unless some
drastic action was taken. Accordingly, Gallant has ordered that wherever possible, expenditures
should be postponed to the new year—including canceling or postponing orders with suppliers,
delaying planned maintenance and training, and cutting back on end-of-year advertising and travel.
Additionally, Gallant ordered the company’s controller to carefully scrutinize all costs that are currently classified as period costs and reclassify as many as possible as product costs. The company
is expected to have substantial inventories at the end of the year.
Required:
1.
2.
Why would reclassifying period costs as product costs increase this period’s reported earnings?
Do you believe Gallant’s actions are ethical? Why or why not?
PROBLEM 2–25 Cost Classification and Cost Behavior [LO2–1, LO2–2, LO2–3, LO2–4]
The Dorilane Company specializes in producing a set of wood patio furniture consisting of a table
and four chairs. The set enjoys great popularity, and the company has ample orders to keep production going at its full capacity of 2,000 sets per year. Annual cost data at full capacity follow:
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . .
Property taxes, factory building . . . . . . . . . . . . . . . .
Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . .
Insurance, factory . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation, administrative office equipment . . . . .
Lease cost, factory equipment . . . . . . . . . . . . . . . . .
Indirect materials, factory . . . . . . . . . . . . . . . . . . . . .
Depreciation, factory building . . . . . . . . . . . . . . . . .
Administrative office supplies (billing) . . . . . . . . . . . .
Administrative office salaries . . . . . . . . . . . . . . . . . .
Direct materials used (wood, bolts, etc.) . . . . . . . . .
Utilities, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$118,000
$50,000
$40,000
$3,500
$80,000
$2,500
$4,000
$12,000
$6,000
$10,000
$3,000
$60,000
$94,000
$20,000
Managerial Accounting and Cost Concepts
65
Required:
1.
Prepare an answer sheet with the column headings shown below. Enter each cost item on your
answer sheet, placing the dollar amount under the appropriate headings. As examples, this has
been done already for the first two items in the list above. Note that each cost item is classified
in two ways: first, as variable or fixed with respect to the number of units produced and sold;
and second, as a selling and administrative cost or a product cost. (If the item is a product cost,
it should also be classified as either direct or indirect as shown.)
Fixed
Period
(Selling or
Administrative)
Cost
$50,000
$50,000
Cost Behavior
Cost Item
Direct labor . . . . . . . . . .
Advertising . . . . . . . . . .
Variable
Product Cost
Direct
$118,000
Indirect*
$118,000
*To units of product.
2.
3.
4.
Total the dollar amounts in each of the columns in (1) above. Compute the average product
cost of one patio set.
Assume that production drops to only 1,000 sets annually. Would you expect the average product
cost per set to increase, decrease, or remain unchanged? Explain. No computations are necessary.
Refer to the original data. The president’s brother-in-law has considered making himself a
patio set and has priced the necessary materials at a building supply store. The brother-in-law
has asked the president if he could purchase a patio set from the Dorilane Company “at cost,”
and the president agreed to let him do so.
a. Would you expect any disagreement between the two men over the price the brotherin-law should pay? Explain. What price does the president probably have in mind? The
brother-in-law?
b. Because the company is operating at full capacity, what cost term used in the chapter
might be justification for the president to charge the full, regular price to the brother-inlaw and still be selling “at cost”?
Cases
All applicable cases are available with McGraw-Hill’s Connect® Accounting.
CASE 2–26 Mixed Cost Analysis and the Relevant Range [LO2–4, LO2–5]
The Ramon Company is a manufacturer that is interested in developing a cost formula to estimate
the fixed and variable components of its monthly manufacturing overhead costs. The company
wishes to use machine-hours as its measure of activity and has gathered the data below for this
year and last year:
Last Year
Month
January . . . . . . . . . . . . . . . . . . .
February . . . . . . . . . . . . . . . . . . .
March . . . . . . . . . . . . . . . . . . .
April . . . . . . . . . . . . . . . . . . . . .
May . . . . . . . . . . . . . . . . . . . . . .
June . . . . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . . . . . . . .
September . . . . . . . . . . . . . . . .
October . . . . . . . . . . . . . . . . . . .
November . . . . . . . . . . . . . . . . .
December . . . . . . . . . . . . . . . . .
This Year
MachineHours
Overhead
Costs
MachineHours
Overhead
Costs
21,000
25,000
22,000
23,000
20,500
19,000
14,000
10,000
12,000
17,000
16,000
19,000
$84,000
$99,000
$89,500
$90,000
$81,500
$75,500
$70,500
$64,500
$69,000
$75,000
$71,500
$78,000
21,000
24,000
23,000
22,000
20,000
18,000
12,000
13,000
15,000
17,000
15,000
18,000
$86,000
$93,000
$93,000
$87,000
$80,000
$76,500
$67,500
$71,000
$73,500
$72,500
$71,000
$75,000
66
Chapter 2
The company leases all of its manufacturing equipment. The lease arrangement calls for a flat
monthly fee up to 19,500 machine-hours. If the machine-hours used exceeds 19,500, then the fee
becomes strictly variable with respect to the total number of machine-hours consumed during the
month. Lease expense is a major element of overhead cost.
Required:
1.
2.
3.
4.
5.
Using the high-low method, estimate a manufacturing overhead cost formula.
Prepare a scattergraph using all of the data for the two-year period. Fit a straight line or lines
to the plotted points using a ruler. Describe the cost behavior pattern revealed by your scattergraph plot.
Assume a least-squares regression analysis using all of the given data points estimated the
total fixed costs to be $40,102 and the variable costs to be $2.13 per machine-hour. Do you
have any concerns about the accuracy of the high-low estimates that you have computed or the
least-squares regression estimates that have been provided?
Assume that the company consumes 22,500 machine-hours during a month. Using the highlow method, estimate the total overhead cost that would be incurred at this level of activity. Be
sure to consider only the data points contained in the relevant range of activity when performing your computations.
Comment on the accuracy of your high-low estimates assuming a least-squares regression
analysis using only the data points in the relevant range of activity estimated the total fixed
costs to be $10,090 and the variable costs to be $3.53 per machine-hour.
CASE 2–27 Scattergraph Analysis; Selection of an Activity Base [LO2–5]
Angora Wraps of Pendleton, Oregon, makes fine sweaters out of pure angora wool. The business is
seasonal, with the largest demand during the fall, the winter, and Christmas holidays. The company
must increase production each summer to meet estimated demand.
The company has been analyzing its costs to determine which costs are fixed and variable
for planning purposes. Below are data for the company’s activity and direct labor costs over the
last year.
Month
January . . . . . . . . . . . . . . . . . . .
February . . . . . . . . . . . . . . . . . .
March . . . . . . . . . . . . . . . . . . . .
April . . . . . . . . . . . . . . . . . . . . . .
May . . . . . . . . . . . . . . . . . . . . . .
June . . . . . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . . . . . . . . .
September . . . . . . . . . . . . . . . . .
October . . . . . . . . . . . . . . . . . . .
November . . . . . . . . . . . . . . . . .
December . . . . . . . . . . . . . . . . .
Thousands of
Units Produced
Number of
Paid Days
Direct Labor
Cost
98
76
75
80
85
102
52
136
138
132
86
56
20
20
21
22
22
21
19
21
22
23
18
21
$14,162
$12,994
$15,184
$15,038
$15,768
$15,330
$13,724
$14,162
$15,476
$15,476
$12,972
$14,074
The number of workdays varies from month to month due to the number of weekdays, holidays, and days of vacation in the month. The paid days include paid vacations (in July) and paid
holidays (in November and December). The number of units produced in a month varies depending on demand and the number of workdays in the month.
The company has eight workers who are classified as direct labor.
Required:
1.
2.
3.
Plot the direct labor cost and units produced on a scattergraph. (Place cost on the vertical axis
and units produced on the horizontal axis.)
Plot the direct labor cost and number of paid days on a scattergraph. (Place cost on the vertical
axis and the number of paid days on the horizontal axis.)
Which measure of activity—number of units produced or paid days—should be used as the
activity base for explaining direct labor cost? Explain.
Managerial Accounting and Cost Concepts
67
Appendix 2A: Least-Squares Regression Computations
The least-squares regression method for estimating a linear relationship is based on the
equation for a straight line:
Y 5 a 1 bX
As explained in the chapter, least-squares regression selects the values for the intercept
a and the slope b that minimize the sum of the squared errors. The following formulas,
which are derived in statistics and calculus texts, accomplish that objective:
n(SXY ) 2 (SX )(SY )
b 5 __________________
n(SX2) 2 (SX )2
(SY ) 2 b(SX )
a 5 ____________
n
where:
X 5 The level of activity (independent variable)
Y 5 The total mixed cost (dependent variable)
a 5 The total fixed cost (the vertical intercept of the line)
b 5 The variable cost per unit of activity (the slope of the line)
n 5 Number of observations
S 5 Sum across all n observations
Manually performing the calculations required by the formulas is tedious at best.
Fortunately, Microsoft® Excel can be used to estimate the intercept (fixed cost) and
slope (variable cost per unit) that minimize the sum of the squared errors. Excel also
provides a statistic called the R2, which is a measure of “goodness of fit.” The R2 tells
us the percentage of the variation in the dependent variable (cost) that is explained by
variation in the independent variable (activity). The R2 varies from 0% to 100%, and the
higher the percentage, the better. You should always plot the data in a scattergraph, but
it is particularly important to check the data visually when the R2 is low. A quick look at
the scattergraph can reveal that there is little relation between the cost and the activity or
that the relation is something other than a simple straight line. In such cases, additional
analysis would be required.
To illustrate how Excel can be used to prepare a scattergraph plot and to calculate the
intercept a, the slope b, and the R2, we will use the Brentline Hospital data for patientdays and maintenance costs on page 39 (which is recreated in Exhibit 2A–1).1
To prepare a scattergraph plot, begin by highlighting the data in cells B4 through
C10. From the Charts group within the Insert tab, select the “Scatter” subgroup and then
click on the choice that has no lines connecting the data points. This should produce a
scattergraph plot similar to the one shown in Exhibit 2A–2. Notice that the number of
patient-days is plotted on the X-axis and the maintenance costs are plotted on the Y-axis.2
The data is approximately linear, so it makes sense to proceed with estimating a regression equation that minimizes the sum of the squared errors.
1
The authors wish to thank Don Schwartz, Professor of Accounting at National University, for providing suggestions that were instrumental in creating this appendix.
2
To insert labels for the X-axis and Y-axis, go to the Layout tab in Excel. Then, within the Labels
group, select Axis Titles.
LO2–8
Analyze a mixed cost using a
scattergraph plot and the leastsquares regression method.
68
Chapter 2
EXHIBIT 2A–1
The Least-Squares Regression
Worksheet for Brentline Hospital
To determine the intercept a, the slope b, and the R2, begin by right clicking on any
data point in the scattergraph plot and selecting “Add Trendline.” This should produce
the screen that is shown in Exhibit 2A–3. Notice that under “Trend/Regression Type”
you should select “Linear.” Similarly, under “Trendline Name” you should select “Automatic.” Next to the word “Backward” you should input the lowest value for the independent variable, which in this example is 5000 patient-days. Taking this particular step
instructs Excel to extend your fitted line until it intersects the Y-axis. Finally, you should
check the two boxes at the bottom of Exhibit 2A–3 that say “Display Equation on chart”
and “Display R-squared value on chart.”
Once you have established these settings, then click “Close.” As shown in Exhibit 2A–4,
this will automatically insert a line within the scattergraph plot that minimizes the sum
of the squared errors. It will also cause the estimated least-squares regression equation and R2 to be inserted into your scattergraph plot. Instead of depicting the results
using the form Y 5 a 1 bX, Excel uses an equivalent form of the equation depicted
as Y 5 bX 1 a. In other words, Excel reverses the two terms shown to the right of the
equals sign. So, in Exhibit 2A–4, Excel shows a least-squares regression equation of
y 5 0.7589x 1 3,430.9. The slope b in this equation of $0.7589 represents the estimated
variable maintenance cost per patient-day. The intercept a in this equation of $3,430.90
(or approximately $3,431) represents the estimated fixed monthly maintenance cost.
Note that the R2 is approximately 0.90, which is quite good and indicates that 90% of the
variation in maintenance costs is explained by the variation in patient-days.
EXHIBIT 2A–2
A Scattergraph Plot for
Brentline Hospital
Managerial Accounting and Cost Concepts
69
EXHIBIT 2A–3
Trendline Options in Microsoft
Excel
EXHIBIT 2A–4
Brentline Hospital: Least-Squares
Regression Results
Glossary (Appendix 2A)
R2 A measure of goodness of fit in least-squares regression analysis. It is the percentage of the
variation in the dependent variable that is explained by variation in the independent variable. (p. 67)
Appendix 2A Exercises and Problems
All applicable exercises and problems are available with McGraw-Hill’s
Connect® Accounting.
EXERCISE 2A–1 Least-Squares Regression [LO2–8]
Bargain Rental Car offers rental cars in an off-airport location near a major tourist destination in California. Management would like to better understand the behavior of the company’s
costs. One of those costs is the cost of washing cars. The company operates its own car wash
70
Chapter 2
facility in which each rental car that is returned is thoroughly cleaned before being released
for rental to another customer. Management believes that the costs of operating the car wash
should be related to the number of rental returns. Accordingly, the following data have been
compiled:
Month
January . . . . . . . . . . . . . . . . . .
February . . . . . . . . . . . . . . . . .
March . . . . . . . . . . . . . . . . . . .
April . . . . . . . . . . . . . . . . . . . .
May . . . . . . . . . . . . . . . . . . . . .
June . . . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . . . . . . .
September . . . . . . . . . . . . . . .
October . . . . . . . . . . . . . . . . .
November . . . . . . . . . . . . . . . .
December . . . . . . . . . . . . . . . .
Rental
Returns
Car Wash
Costs
2,380
2,421
2,586
2,725
2,968
3,281
3,353
3,489
3,057
2,876
2,735
2,983
$10,825
$11,865
$11,332
$12,422
$13,850
$14,419
$14,935
$15,738
$13,563
$11,889
$12,683
$13,796
Required:
1.
2.
Prepare a scattergraph plot. (Place car wash costs on the vertical axis and rental returns on the
horizontal axis.)
Using least-squares regression, estimate the fixed cost and variable cost elements of monthly
car wash costs. The fixed cost element should be estimated to the nearest dollar and the variable cost element to the nearest cent.
EXERCISE 2A–2 Least-Squares Regression [LO2–4, LO2–8]
George Caloz & Frères, located in Grenchen, Switzerland, makes prestige high-end custom
watches in small lots. One of the company’s products, a platinum diving watch, goes through an
etching process. The company has observed etching costs as follows over the last six weeks:
Week
1...........
2...........
3...........
4...........
5...........
6...........
Units
Total Etching Cost
4
3
8
6
7
2
$ 18
17
25
20
24
16
30
$120
For planning purposes, management would like to know the amount of variable etching cost
per unit and the total fixed etching cost per week.
Required:
1.
2.
3.
Prepare a scattergraph plot. (Place etching costs on the vertical axis and units on the horizontal axis.)
Using the least-squares regression method, estimate the variable and fixed elements of etching
cost. Express these estimates in the form Y 5 a 1 bX.
If the company processes five units next week, what would be the expected total etching cost?
PROBLEM 2A–3 Least-Squares Regression; Scattergraph; Comparison of Activity Bases [LO2–4, LO2–8]
The Hard Rock Mining Company is developing cost formulas for management planning and
decision-making purposes. The company’s cost analyst has concluded that utilities cost is a mixed
cost, and he is attempting to find a base with which the cost might be closely correlated. The controller has suggested that tons mined might be a good base to use in developing a cost formula. The
Managerial Accounting and Cost Concepts
production superintendent disagrees; she thinks that direct labor-hours would be a better base. The
cost analyst has decided to try both bases and has assembled the following information:
Quarter
Year 1:
First . . . . . . . . . . . . . . . . . .
Second . . . . . . . . . . . . . . .
Third . . . . . . . . . . . . . . . .
Fourth . . . . . . . . . . . . . . . .
Year 2:
First . . . . . . . . . . . . . . . . . .
Second . . . . . . . . . . . . . . .
Third . . . . . . . . . . . . . . . .
Fourth . . . . . . . . . . . . . . .
Tons
Mined
Direct
Labor-Hours
Utilities
Cost
15,000
11,000
21,000
12,000
5,000
3,000
4,000
6,000
$50,000
$45,000
$60,000
$75,000
18,000
25,000
30,000
28,000
10,000
9,000
8,000
11,000
$100,000
$105,000
$85,000
$120,000
Required:
1.
2.
3.
Using tons mined as the independent variable, prepare a scattergraph that plots tons mined on
the horizontal axis and utilities cost on the vertical axis. Determine a cost formula for utilities
cost using least-squares regression. Express this cost formula in the form Y 5 a 1 bX.
Using direct labor-hours as the independent variable, prepare a scattergraph that plots direct
labor-hours on the horizontal axis and utilities cost on the vertical axis. Determine a cost formula
for utilities cost using least-squares regression. Express this cost formula in the form Y 5 a 1 bX.
Would you recommend that the company use tons mined or direct labor-hours as a base for
planning utilities cost?
PROBLEM 2A–4 Least-Squares Regression Method; Scattergraph; Cost Behavior [LO2–4, LO2–8]
Professor John Morton has just been appointed chairperson of the Finance Department at Westland
University. In reviewing the department’s cost records, Professor Morton has found the following
total cost associated with Finance 101 over the last several terms:
Term
Fall, last year . . . . . . . . . . .
Winter, last year . . . . . . . . .
Summer, last year . . . . . . .
Fall, this year . . . . . . . . . . .
Winter, this year . . . . . . . . .
Number of
Sections Offered
Total Cost
4
6
2
5
3
$10,000
$14,000
$7,000
$13,000
$9,500
Professor Morton knows that there are some variable costs, such as amounts paid to graduate
assistants, associated with the course. He would like to have the variable and fixed costs separated
for planning purposes.
Required:
1.
2.
3.
Prepare a scattergraph plot. (Place total cost on the vertical axis and number of sections
offered on the horizontal axis.)
Using the least-squares regression method, estimate the variable cost per section and the
total fixed cost per term for Finance 101. Express these estimates in the linear equation form
Y 5 a 1 bX.
Assume that because of the small number of sections offered during the Winter Term this
year, Professor Morton will have to offer eight sections of Finance 101 during the Fall Term.
Compute the expected total cost for Finance 101. Can you see any problem with using the cost
formula from (2) above to derive this total cost figure? Explain.
CASE 2A–5 Analysis of Mixed Costs in a Pricing Decision [LO2–4, LO2–8]
Maria Chavez owns a catering company that serves food and beverages at parties and business
functions. Chavez’s business is seasonal, with a heavy schedule during the summer months and
holidays and a lighter schedule at other times.
71
72
Chapter 2
One of the major events Chavez’s customers request is a cocktail party. She offers a standard
cocktail party and has estimated the cost per guest as follows:
Food and beverages . . . . . . . . . . . . . . .
Labor (0.5 hrs. @ $10.00/hr.) . . . . . . . . .
Overhead (0.5 hrs. @ $13.98/hr.) . . . . . .
$15.00
5.00
6.99
Total cost per guest . . . . . . . . . . . . . . . .
$26.99
The standard cocktail party lasts three hours and Chavez hires one worker for every six guests,
so that works out to one-half hour of labor per guest. These workers are hired only as needed and
are paid only for the hours they actually work.
When bidding on cocktail parties, Chavez adds a 15% markup to yield a price of about
$31 per guest. She is confident about her estimates of the costs of food and beverages and
labor but is not as comfortable with the estimate of overhead cost. The $13.98 overhead cost
per labor-hour was determined by dividing total overhead expenses for the last 12 months
by total labor-hours for the same period. Monthly data concerning overhead costs and laborhours follow:
LaborHours
Overhead
Expenses
January . . . . . .
February . . . . .
March . . . . . . . .
April . . . . . . . . .
May . . . . . . . . .
June . . . . . . . .
July . . . . . . . . .
August . . . . . . .
September . . . .
October . . . . . .
November . . . .
December . . . .
2,500
2,800
3,000
4,200
4,500
5,500
6,500
7,500
7,000
4,500
3,100
6,500
$ 55,000
59,000
60,000
64,000
67,000
71,000
74,000
77,000
75,000
68,000
62,000
73,000
Total . . . . . . . . .
57,600
$805,000
Month
Chavez has received a request to bid on a 180-guest fund-raising cocktail party to be
given next month by an important local charity. (The party would last the usual three hours.)
She would like to win this contract because the guest list for this charity event includes many
prominent individuals that she would like to land as future clients. Maria is confident that
these potential customers would be favorably impressed by her company’s services at the
charity event.
Required:
1.
2.
3.
4.
5.
Prepare a scattergraph plot that puts labor-hours on the X-axis and overhead expenses on the
Y-axis. What insights are revealed by your scattergraph?
Use the least-squares regression method to estimate the fixed and variable components of
overhead expenses. Express these estimates in the form Y 5 a 1 bX.
Estimate the contribution to profit of a standard 180-guest cocktail party if Chavez charges
her usual price of $31 per guest. (In other words, by how much would her overall profit
increase?)
How low could Chavez bid for the charity event in terms of a price per guest and still not lose
money on the event itself?
The individual who is organizing the charity’s fund-raising event has indicated that he has
already received a bid under $30 from another catering company. Do you think Chavez should
bid below her normal $31 per guest price for the charity event? Why or why not?
(CMA, adapted)
Managerial Accounting and Cost Concepts
73
Appendix 2B: Cost of Quality
A company may have a product with a high-quality design that uses high-quality components, but if the product is poorly assembled or has other defects, the company will
have high warranty repair costs and dissatisfied customers. People who are dissatisfied
with a product are unlikely to buy the product again. They often tell others about their
bad experiences. This is the worst possible sort of advertising. To prevent such problems,
companies expend a great deal of effort to reduce defects. The objective is to have high
quality of conformance.
Quality of Conformance
A product that meets or exceeds its design specifications and is free of defects that mar its
appearance or degrade its performance is said to have high quality of conformance. Note
that if an economy car is free of defects, it can have a quality of conformance that is just as
high as a defect-free luxury car. The purchasers of economy cars cannot expect their cars to
be as opulently equipped as luxury cars, but they can and do expect them to be free of defects.
Preventing, detecting, and dealing with defects causes costs that are called quality
costs or the cost of quality. The use of the term quality cost is confusing to some people. It
does not refer to costs such as using a higher-grade leather to make a wallet or using 14K
gold instead of gold-plating in jewelry. Instead, the term quality cost refers to all of the
costs that are incurred to prevent defects or that result from defects in products.
Quality costs can be broken down into four broad groups. Two of these groups—
known as prevention costs and appraisal costs—are incurred in an effort to keep defective
products from falling into the hands of customers. The other two groups of costs—known
as internal failure costs and external failure costs—are incurred because defects occur
despite efforts to prevent them. Examples of specific costs involved in each of these four
groups are given in Exhibit 2B–1.
Several things should be noted about the quality costs shown in the exhibit. First,
quality costs don’t relate to just manufacturing; rather, they relate to all the activities in
a company from initial research and development (R&D) through customer service. Second, the number of costs associated with quality is very large; total quality cost can be
very high unless management gives this area special attention. Finally, the costs in the four
groupings are quite different. We will now look at each of these groupings more closely.
Prevention Costs
Generally, the most effective way to manage quality costs is to avoid having defects in
the first place. It is much less costly to prevent a problem from ever happening than it is
to find and correct the problem after it has occurred. Prevention costs support activities
whose purpose is to reduce the number of defects.
Note from Exhibit 2B–1 that prevention costs include activities relating to quality
circles and statistical process control. Quality circles consist of small groups of employees that meet on a regular basis to discuss ways to improve quality. Both management and
workers are included in these circles. Quality circles are widely used and can be found
in manufacturing companies, utilities, health care organizations, banks, and many other
organizations.
Statistical process control is a technique that is used to detect whether a process
is in or out of control. An out-of-control process results in defective units and may be
caused by a miscalibrated machine or some other factor. In statistical process control,
workers use charts to monitor the quality of units that pass through their workstations.
With these charts, workers can quickly spot processes that are out of control and that are
creating defects. Problems can be immediately corrected and further defects prevented
rather than waiting for an inspector to catch the defects later.
Note also from the list of prevention costs in Exhibit 2B–1 that some companies
provide technical support to their suppliers as a way of preventing defects. Particularly
LO2–9
Identify the four types of quality
costs and explain how they
interact.
74
EXHIBIT 2B–1
Typical Quality Costs
Chapter 2
Prevention Costs
Internal Failure Costs
Systems development
Quality engineering
Quality training
Quality circles
Statistical process control activities
Supervision of prevention activities
Quality data gathering, analysis, and
reporting
Quality improvement projects
Technical support provided to suppliers
Audits of the effectiveness of the
quality system
Net cost of scrap
Net cost of spoilage
Rework labor and overhead
Reinspection of reworked products
Retesting of reworked products
Downtime caused by quality problems
Disposal of defective products
Analysis of the cause of defects in
production
Re-entering data because of keying
errors
Debugging software errors
Appraisal Costs
External Failure Costs
Test and inspection of incoming
materials
Test and inspection of in-process goods
Final product testing and inspection
Supplies used in testing and inspection
Supervision of testing and inspection
activities
Depreciation of test equipment
Maintenance of test equipment
Plant utilities in the inspection area
Field testing and appraisal at
customer site
Cost of field servicing and handling
complaints
Warranty repairs and replacements
Repairs and replacements beyond the
warranty period
Product recalls
Liability arising from defective products
Returns and allowances arising from
quality problems
Lost sales arising from a reputation for
poor quality
in just-in-time (JIT) systems, such support to suppliers is vital. In a JIT system, parts
are delivered from suppliers just in time and in just the correct quantity to fill customer
orders. There are no parts stockpiles. If a defective part is received from a supplier, the
part cannot be used and the order for the ultimate customer cannot be filled on time.
Hence, every part received from a supplier must be free of defects. Consequently, companies that use JIT often require that their suppliers use sophisticated quality control
programs such as statistical process control and that their suppliers certify that they will
deliver parts and materials that are free of defects.
Appraisal Costs
Any defective parts and products should be caught as early as possible in the production
process. Appraisal costs, which are sometimes called inspection costs, are incurred to
identify defective products before the products are shipped to customers. Unfortunately,
performing appraisal activities doesn’t keep defects from happening again, and most
managers now realize that maintaining an army of inspectors is a costly (and ineffective)
approach to quality control. Therefore, employees are increasingly being asked to be
responsible for their own quality control. This approach, along with designing products
to be easy to manufacture properly, allows quality to be built into products rather than
relying on inspection to get the defects out.
Internal Failure Costs
Failure costs are incurred when a product fails to conform to its design specifications.
Failure costs can be either internal or external. Internal failure costs result from identifying defects before they are shipped to customers. These costs include scrap, rejected
Managerial Accounting and Cost Concepts
75
products, reworking of defective units, and downtime caused by quality problems. In
some companies, as little as 10% of the company’s products make it through the production process without rework of some kind. Of course, the more effective a company’s
appraisal activities, the greater the chance of catching defects internally and the greater
the level of internal failure costs. This is the price that is paid to avoid incurring external
failure costs, which can be devastating.
External Failure Costs
External failure costs result when a defective product is delivered to a customer. As
shown in Exhibit 2B–1, external failure costs include warranty repairs and replacements,
product recalls, liability arising from legal action against a company, and lost sales arising from a reputation for poor quality. Such costs can decimate profits.
In the past, some managers have taken the attitude, “Let’s go ahead and ship everything to customers, and we’ll take care of any problems under the warranty.” This attitude
generally results in high external failure costs, customer ill will, and declining market
share and profits.
Distribution of Quality Costs
Quality costs for some companies range between 10% and 20% of total sales, whereas
experts say that these costs should be more in the 2% to 4% range. How does a company
reduce its total quality cost? The answer lies in how the quality costs are distributed.
Refer to the graph in Exhibit 2B–2, which shows total quality costs as a function of the
quality of conformance.
The graph shows that when the quality of conformance is low, total quality cost is
high and that most of this cost consists of costs of internal and external failure. A low
quality of conformance means that a high percentage of units are defective and hence
the company has high failure costs. However, as a company spends more and more on
prevention and appraisal, the percentage of defective units drops. This results in lower
internal and external failure costs. Ordinarily, total quality cost drops rapidly as the quality of conformance increases. Thus, a company can reduce its total quality cost by focusing its efforts on prevention and appraisal. The cost savings from reduced defects usually
swamp the costs of the additional prevention and appraisal efforts.
Costs
EXHIBIT 2B–2
Effect of Quality Costs on
Quality of Conformance
Costs of
internal and
external failure
Total
quality cost
Costs of
prevention and
appraisal
0
100
Quality of conformance
(percent of output without defects)
76
Chapter 2
The graph in Exhibit 2B–2 has been drawn so that the total quality cost is minimized
when the quality of conformance is less than 100%. However, some experts contend that
the total quality cost is not minimized until the quality of conformance is 100% and there
are no defects. Indeed, many companies have found that the total quality costs seem to
keep dropping even when the quality of conformance approaches 100% and defect rates
get as low as 1 in a million units. Others argue that total quality cost eventually increases
as the quality of conformance increases. However, in most companies this does not seem
to happen until the quality of conformance is very close to 100% and defect rates are very
close to zero.
As a company’s quality program becomes more refined and as its failure costs begin
to fall, prevention activities usually become more effective than appraisal activities.
Appraisal can only find defects, whereas prevention can eliminate them. The best way
to prevent defects from happening is to design processes that reduce the likelihood of
defects and to continually monitor processes using statistical process control methods.
Quality Cost Reports
LO2–10
Prepare and interpret a quality
cost report.
As an initial step in quality improvement programs, companies often construct a quality
cost report that provides an estimate of the financial consequences of the company’s current level of defects. A quality cost report details the prevention costs, appraisal costs,
and costs of internal and external failures that arise from the company’s current quality
control efforts. Managers are often shocked by the magnitude of these costs. A typical
quality cost report is shown in Exhibit 2B–3.
Several things should be noted from the data in the exhibit. First, Ventura Company’s
quality costs are poorly distributed in both years, with most of the costs due to either
internal failure or external failure. The external failure costs are particularly high in Year
1 in comparison to other costs.
Second, note that the company increased its spending on prevention and appraisal
activities in Year 2. As a result, internal failure costs went up in that year (from $2 million in Year 1 to $3 million in Year 2), but external failure costs dropped sharply (from
$5.15 million in Year 1 to only $2 million in Year 2). Because of the increase in appraisal
activity in Year 2, more defects were caught inside the company before they were shipped
to customers. This resulted in more cost for scrap, rework, and so forth, but saved huge
amounts in warranty repairs, warranty replacements, and other external failure costs.
Third, note that as a result of greater emphasis on prevention and appraisal, total quality cost decreased in Year 2. As continued emphasis is placed on prevention and appraisal
in future years, total quality cost should continue to decrease. That is, future increases in
prevention and appraisal costs should be more than offset by decreases in failure costs.
Moreover, appraisal costs should also decrease as more effort is placed into prevention.
Quality Cost Reports in Graphic Form
As a supplement to the quality cost report shown in Exhibit 2B–3, companies frequently
prepare quality cost information in graphic form. Graphic presentations include pie charts,
bar graphs, trend lines, and so forth. The data for Ventura Company from Exhibit 2B–3
are presented in bar graph form in Exhibit 2B–4.
The first bar graph in Exhibit 2B–4 is scaled in terms of dollars of quality cost, and
the second is scaled in terms of quality cost as a percentage of sales. In both graphs, the
data are “stacked” upward. That is, appraisal costs are stacked on top of prevention costs,
internal failure costs are stacked on top of the sum of prevention costs plus appraisal
costs, and so forth. The percentage figures in the second graph show that total quality cost
equals 18% of sales in Year 1 and 15% of sales in Year 2, the same as reported earlier in
Exhibit 2B–3.
Managerial Accounting and Cost Concepts
77
EXHIBIT 2B–3
Quality Cost Report
Ventura Company
Quality Cost Report
For Years 1 and 2
Year 1
Prevention costs:
Systems development . . . . . . . . . . . . . . . . . . . . . . . . .
Quality training . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Supervision of prevention activities . . . . . . . . . . . . . . . .
Quality improvement projects . . . . . . . . . . . . . . . . . . . .
Total prevention cost . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Appraisal costs:
Inspection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reliability testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Supervision of testing and inspection . . . . . . . . . . . . . .
Depreciation of test equipment . . . . . . . . . . . . . . . . . . .
Total appraisal cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Internal failure costs:
Net cost of scrap . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Rework labor and overhead . . . . . . . . . . . . . . . . . . . . .
Downtime due to defects in quality . . . . . . . . . . . . . . . .
Disposal of defective products . . . . . . . . . . . . . . . . . . .
Total internal failure cost . . . . . . . . . . . . . . . . . . . . . . . . . .
External failure costs:
Warranty repairs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Warranty replacements . . . . . . . . . . . . . . . . . . . . . . . .
Allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of field servicing . . . . . . . . . . . . . . . . . . . . . . . . . .
Total external failure cost . . . . . . . . . . . . . . . . . . . . . . . . .
Total quality cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Year 2
Amount
Percent*
Amount
Percent*
$ 270,000
130,000
40,000
210,000
650,000
0.54%
0.26%
0.08%
0.42%
1.30%
$ 400,000
210,000
70,000
320,000
1,000,000
0.80%
0.42%
0.14%
0.64%
2.00%
560,000
420,000
80,000
140,000
1,200,000
1.12%
0.84%
0.16%
0.28%
2.40%
600,000
580,000
120,000
200,000
1,500,000
1.20%
1.16%
0.24%
0.40%
3.00%
750,000
810,000
100,000
340,000
2,000,000
1.50%
1.62%
0.20%
0.68%
4.00%
900,000
1,430,000
170,000
500,000
3,000,000
1.80%
2.86%
0.34%
1.00%
6.00%
900,000
2,300,000
630,000
1,320,000
5,150,000
$9,000,000
1.80%
4.60%
1.26%
2.64%
10.30%
18.00%
400,000
870,000
130,000
600,000
2,000,000
$7,500,000
0.80%
1.74%
0.26%
1.20%
4.00%
15.00%
*As a percentage of total sales. In each year, sales totaled $50,000,000.
Data in graphic form help managers to see trends more clearly and to see the magnitude of the various costs in relation to each other. Such graphs are easily prepared using
computer graphics and spreadsheet applications.
Uses of Quality Cost Information
A quality cost report has several uses. First, quality cost information helps managers see
the financial significance of defects. Managers usually are not aware of the magnitude of
their quality costs because these costs cut across departmental lines and are not normally
tracked and accumulated by the cost system. Thus, when first presented with a quality cost
report, managers often are surprised by the amount of cost attributable to poor quality.
Second, quality cost information helps managers identify the relative importance of
the quality problems faced by their companies. For example, the quality cost report may
show that scrap is a major quality problem or that the company is incurring huge warranty
costs. With this information, managers have a better idea of where to focus their efforts.
Third, quality cost information helps managers see whether their quality costs are
poorly distributed. In general, quality costs should be distributed more toward prevention
and appraisal activities and less toward failures.
Chapter 2
EXHIBIT 2B–4
Quality Cost Reports in
Graphic Form
$10
20
9
18
Quality cost (in millions)
8
7
6
External
failure
External
failure
5
Internal
failure
4
3
Internal
failure
2
1
0
Appraisal
Appraisal
16
14
12
Year
Internal
failure
8
6
Internal
failure
4
Prevention
2
External
failure
External
failure
10
2
Prevention
1
Quality cost as a percentage of sales
78
0
Appraisal
Appraisal
Prevention
1
Year
Prevention
2
Counterbalancing these uses, three limitations of quality cost information should
be recognized. First, simply measuring and reporting quality costs does not solve quality problems. Problems can be solved only by taking action. Second, results usually lag
behind quality improvement programs. Initially, total quality cost may even increase as
quality control systems are designed and installed. Decreases in quality costs may not
begin to occur until the quality program has been in effect for some time. And third, the
most important quality cost, lost sales arising from customer ill will, is usually omitted
from the quality cost report because it is difficult to estimate.
Typically, during the initial years of a quality improvement program, the benefits
of compiling a quality cost report outweigh the costs and limitations of the reports. As
managers gain experience in balancing prevention and appraisal activities, the need for
quality cost reports often diminishes.
International Aspects of Quality
Many of the tools used in quality management today were developed in Japan after World
War II. In statistical process control, Japanese companies borrowed heavily from the
work of W. Edwards Deming. However, Japanese companies are largely responsible for
quality circles, JIT, the idea that quality is everyone’s responsibility, and the emphasis on
prevention rather than on inspection.
In the 1980s, quality reemerged as a pivotal factor in the market. Many companies now
find that it is impossible to effectively compete without a very strong quality program in
place. This is particularly true of companies that wish to compete in the European market.
The ISO 9000 Standards
The International Organization for Standardization (ISO), based in Geneva, Switzerland,
has established quality control guidelines known as the ISO 9000 standards. Many companies and organizations in Europe will buy only from ISO 9000-certified suppliers. This
means that the suppliers must demonstrate to a certifying agency that:
Managerial Accounting and Cost Concepts
1. A quality control system is in use, and the system clearly defines an expected level of
quality.
2. The system is fully operational and is backed up with detailed documentation of
quality control procedures.
3. The intended level of quality is being achieved on a sustained, consistent basis.
The key to receiving certification under the ISO 9000 standards is documentation. It’s
one thing for a company to say that it has a quality control system in operation, but it’s
quite a different thing to be able to document the steps in that system. Under ISO 9000,
this documentation must be so detailed and precise that if all the employees in a company were suddenly replaced, the new employees could use the documentation to make
the product exactly as it was made by the old employees. Even companies with good
quality control systems find that it takes up to two years of painstaking work to develop
this detailed documentation. But companies often find that compiling this documentation
results in improvements in their quality systems.
The ISO 9000 standards have become an international measure of quality. Although
the standards were developed to control the quality of goods sold in European countries, they have become widely accepted elsewhere as well. Companies in the United
States that export to Europe often expect their own suppliers to comply with ISO 9000
standards because these exporters must document the quality of the materials going into
their products as part of their own ISO 9000 certification.
The ISO program for certification of quality management programs is not limited to
manufacturing companies. The American Institute of Certified Public Accountants was
the first professional membership organization in the United States to win recognition
under an ISO certification program.
Summary (Appendix 2B)
Defects cause costs, which can be classified into prevention costs, appraisal costs, internal failure
costs, and external failure costs. Prevention costs are incurred to keep defects from happening.
Appraisal costs are incurred to ensure that defective products, once made, are not shipped to customers. Internal failure costs are incurred as a consequence of detecting defective products before
they are shipped to customers. External failure costs are the consequences (in terms of repairs, servicing, and lost future business) of delivering defective products to customers. Most experts agree
that management effort should be focused on preventing defects. Small investments in prevention
can lead to dramatic reductions in appraisal costs and costs of internal and external failure.
Quality costs are summarized on a quality cost report. This report shows the types of quality
costs being incurred and their significance and trends. The report helps managers understand the
importance of quality costs, spot problem areas, and assess the way in which the quality costs are
distributed.
Glossary (Appendix 2B)
Appraisal costs Costs that are incurred to identify defective products before the products are
shipped to customers. (p. 74)
External failure costs Costs that are incurred when a product or service that is defective is delivered to a customer. (p. 75)
Internal failure costs Costs that are incurred as a result of identifying defective products before
they are shipped to customers. (p. 74)
ISO 9000 standards Quality control requirements issued by the International Organization for
Standardization that relate to products sold in European countries. (p. 78)
Prevention costs Costs that are incurred to keep defects from occurring. (p. 73)
79
80
Chapter 2
Quality circles Small groups of employees that meet on a regular basis to discuss ways of improving quality. (p. 73)
Quality cost Costs that are incurred to prevent defective products from falling into the hands of
customers or that are incurred as a result of defective units. (p. 73)
Quality cost report A report that details prevention costs, appraisal costs, and the costs of internal and external failures. (p. 76)
Quality of conformance The degree to which a product or service meets or exceeds its design
specifications and is free of defects or other problems that mar its appearance or degrade its
performance. (p. 73)
Statistical process control A charting technique used to monitor the quality of work being done
in a workstation for the purpose of immediately correcting any problems. (p. 73)
Appendix 2B Exercises and Problems
All applicable exercises and problems are available with McGraw-Hill’s Connect®
Accounting.
EXERCISE 2B–1 Cost of Quality Terms [LO2–9]
A number of terms relating to the cost of quality and quality management are listed below:
Appraisal costs
Quality cost report
Quality of conformance
Internal failure costs
Quality circles
Prevention costs
External failure costs
Quality costs
Required:
Choose the term or terms that most appropriately complete the following statements. The terms
can be used more than once and a blank can hold more than one word.
.
1. A product that has a high rate of defects is said to have a low
2. All of the costs associated with preventing and dealing with defects once they occur are
.
known as
,
3. In many companies, small groups of employees, known as
meet on a regular basis to discuss ways to improve quality.
and
in an
4. A company incurs
effort to keep defects from occurring.
and
5. A company incurs
because defects have occurred.
6. Of the four groups of costs associated with quality of conformance,
are generally the most damaging to a company.
7. Inspection, testing, and other costs incurred to keep defective products from being shipped to
.
customers are known as
are incurred in an effort to eliminate poor product design,
8.
defective manufacturing practices, and the providing of substandard service.
9. The costs relating to defects, rejected products, and downtime caused by quality problems are
.
known as
10. When a product that is defective in some way is delivered to a customer,
are incurred.
11. Over time a company’s total quality costs should decrease if it redistributes its quality costs by
and
.
placing its greatest emphasis on
12. One way to ensure that management is aware of the costs associated with quality is to sum.
marize such costs on a
EXERCISE 2B–2 Classification of Quality Costs [LO2–9]
A number of activities that are a part of a company’s quality control system are listed below:
a.
b.
c.
d.
e.
Product testing.
Product recalls.
Rework labor and overhead.
Quality circles.
Downtime caused by defects.
f.
g.
h.
i.
j.
Cost of field servicing.
Inspection of goods.
Quality engineering.
Warranty repairs.
Statistical process control.
Managerial Accounting and Cost Concepts
k. Net cost of scrap.
l. Depreciation of test equipment.
m. Returns and allowances arising from poor
quality.
n. Disposal of defective products.
o.
p.
q.
r.
s.
Technical support to suppliers.
Systems development.
Warranty replacements.
Field testing at customer site.
Product design.
Required:
1.
2.
Classify the costs associated with each of these activities into one of the following categories:
prevention cost, appraisal cost, internal failure cost, or external failure cost.
Which of the four types of costs in (1) above are incurred in an effort to keep poor quality
of conformance from occurring? Which of the four types of costs in (1) above are incurred
because poor quality of conformance has occurred?
PROBLEM 2B–3 Analyzing a Quality Cost Report [LO2–10]
Mercury, Inc., produces cell phones at its plant in Texas. In recent years, the company’s market
share has been eroded by stiff competition from overseas. Price and product quality are the two key
areas in which companies compete in this market.
A year ago, the company’s cell phones had been ranked low in product quality in a consumer survey. Shocked by this result, Jorge Gomez, Mercury’s president, initiated a crash effort
to improve product quality. Gomez set up a task force to implement a formal quality improvement
program. Included on this task force were representatives from the Engineering, Marketing, Customer Service, Production, and Accounting departments. The broad representation was needed
because Gomez believed that this was a companywide program and that all employees should
share the responsibility for its success.
After the first meeting of the task force, Holly Elsoe, manager of the Marketing Department,
asked John Tran, production manager, what he thought of the proposed program. Tran replied,
“I have reservations. Quality is too abstract to be attaching costs to it and then to be holding you
and me responsible for cost improvements. I like to work with goals that I can see and count! I’m
nervous about having my annual bonus based on a decrease in quality costs; there are too many
variables that we have no control over.”
Mercury’s quality improvement program has now been in operation for one year. The company’s most recent quality cost report is shown below.
Mercury, Inc.
Quality Cost Report
(in thousands)
Last Year
This Year
Prevention costs:
Machine maintenance . . . . . . . . . . . $ 70
Training suppliers . . . . . . . . . . . . . . . . . . 0
Quality circles . . . . . . . . . . . . . . . . . . . . . 0
$ 120
10
20
Total prevention costs . . . . . . . . . . . . . . . . 70
150
Appraisal costs:
Incoming inspection . . . . . . . . . . . . . . . 20
Final testing . . . . . . . . . . . . . . . . . . . . . . 80
40
90
Total appraisal costs . . . . . . . . . . . . . . . . 100
130
Internal failure costs:
Rework . . . . . . . . . . . . . . . . . . . . . . . . . 50
Scrap . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
130
70
Total internal failure costs . . . . . . . . . . . . . 90
200
External failure costs:
Warranty repairs . . . . . . . . . . . . . . . . . . 90
Customer returns . . . . . . . . . . . . . . . . 320
30
80
Total external failure costs . . . . . . . . . . . 410
110
Total quality cost . . . . . . . . . . . . . . . . $ 670
$ 590
Total production cost . . . . . . . . . . . . $4,200
$4,800
81
82
Chapter 2
As they were reviewing the report, Elsoe asked Tran what he now thought of the quality
improvement program. Tran replied. “I’m relieved that the new quality improvement program
hasn’t hurt our bonuses, but the program has increased the workload in the Production Department.
It is true that customer returns are way down, but the cell phones that were returned by customers
to retail outlets were rarely sent back to us for rework.”
Required:
1.
2.
3.
Expand the company’s quality cost report by showing the costs in both years as percentages of
both total production cost and total quality cost. Carry all computations to one decimal place.
By analyzing the report, determine if Mercury, Inc.’s quality improvement program has been
successful. List specific evidence to support your answer.
Do you expect the improvement program as it progresses to continue to increase the workload
in the Production Department?
Jorge Gomez believed that the quality improvement program was essential and that Mercury,
Inc., could no longer afford to ignore the importance of product quality. Discuss how Mercury, Inc., could measure the cost of not implementing the quality improvement program.
(CMA, adapted)
PROBLEM 2B–4 Quality Cost Report [LO2–9, LO2–10]
In response to intensive foreign competition, the management of Florex Company has attempted
over the past year to improve the quality of its products. A statistical process control system has
been installed and other steps have been taken to decrease the amount of warranty and other field
costs, which have been trending upward over the past several years. Costs relating to quality and
quality control over the last two years are given below:
Costs (in thousands)
Inspection . . . . . . . . . . . . . . . . . . . . .
Quality engineering . . . . . . . . . . . . . .
Depreciation of test equipment . . . .
Rework labor . . . . . . . . . . . . . . . . . . .
Statistical process control . . . . . . . .
Cost of field servicing . . . . . . . . . . . .
Supplies used in testing . . . . . . . . . .
Systems development . . . . . . . . . . .
Warranty repairs . . . . . . . . . . . . . . . .
Net cost of scrap . . . . . . . . . . . . . . .
Product testing . . . . . . . . . . . . . . . . .
Product recalls . . . . . . . . . . . . . . . . .
Disposal of defective products . . . . .
Last Year
This Year
$750
$420
$210
$1,050
$0
$1,200
$30
$480
$3,600
$630
$810
$2,100
$720
$900
$570
$240
$1,500
$180
$900
$60
$750
$1,050
$1,125
$1,200
$750
$975
Sales have been flat over the past few years, at $75,000,000 per year. A great deal of money has
been spent in the effort to upgrade quality, and management is anxious to see whether or not the
effort has been effective.
Required:
1.
2.
3.
Prepare a quality cost report that contains data for both this year and last year. Carry percentage computations to two decimal places.
Prepare a bar graph showing the distribution of the various quality costs by category.
Prepare a written evaluation to accompany the reports you have prepared in (1) and (2) above.
This evaluation should discuss the distribution of quality costs in the company, changes in this
distribution that you see taking place, the reasons for changes in costs in the various categories, and any other information that would be of value to management.
CHAPTER 3
Job-Order Costing
University Tees: Serving Over
150 Campuses Nationwide
BUSIN ESS FO CUS
LEARNING OBJECTIVES
After studying Chapter 3, you should be
able to:
University Tees was founded in 2003 by two Miami University college
students to provide screen-printing, embroidery, and promotional products
for fraternities, sororities, and student organizations. Today, the company,
which is headquartered in Cleveland, Ohio, employs as many as four Campus
Managers on each of over 150 college campuses across America.
Accurately calculating the cost of each potential customer order is
critically important to University Tees because the company needs to be
sure that the sales price exceeds the cost associated with satisfying the
order. The costs include the cost of the blank T-shirts themselves, printing costs (which vary depending on the quantity of shirts produced and the
number of colors per shirt), screen costs (which also vary depending on
the number of colors included in a design), shipping costs, and the artwork
needed to create a design. The company also takes into account its competitors’ pricing strategies when developing its own prices.
Given its success on college campuses, University Tees has introduced a
sister company called On Point Promos to serve for-profit companies and
nonprofit organizations. ■
Source: Conversation with Joe Haddad, cofounder of University Tees.
LO3–1
Compute a predetermined overhead
rate.
LO3–2
Apply overhead cost to jobs using a
predetermined overhead rate.
LO3–3
Compute the total cost and average
cost per unit of a job.
LO3–4
Understand the flow of costs in a joborder costing system and prepare
appropriate journal entries to record
costs.
LO3–5
Use T-accounts to show the flow of
costs in a job-order costing system.
LO3–6
Prepare schedules of cost of goods
manufactured and cost of goods sold
and an income statement.
LO3–7
Compute underapplied or overapplied
overhead cost and prepare the
journal entry to close the balance
in Manufacturing Overhead to the
appropriate accounts.
LO3–8
(Appendix 3A) Use activity-based
absorption costing to compute unit
product costs.
LO3–9
(Appendix 3B) Understand
the implications of basing the
predetermined overhead rate on activity
at capacity rather than on estimated
activity for the period.
83
84
Chapter 3
nderstanding how products and services are costed is vital to
U
managers because the way in which these costs are determined can have a substantial impact on reported profits, as well as on key management decisions.
A managerial costing system should provide cost data to help managers plan, control, and make decisions. Nevertheless, external financial reporting and
tax reporting requirements often heavily influence how costs are accumulated and summarized on managerial reports. This is true of product costing. In this chapter we use
absorption costing to determine product costs. In absorption costing, all manufacturing
costs, both fixed and variable, are assigned to units of product—units are said to fully
absorb manufacturing costs.
Most countries—including the United States—require some form of absorption
costing for both external financial reports and for tax reports. In addition, the vast
majority of companies throughout the world also use absorption costing in their management reports. Because absorption costing is the most common approach to product
costing throughout the world, we discuss it first and then discuss the alternatives in
subsequent chapters.
Job-Order Costing—An Overview
Under absorption costing, product costs include all manufacturing costs. Some manufacturing costs, such as direct materials, can be directly traced to particular products.
For example, the cost of the airbags installed in a Toyota Camry can be easily traced
to that particular auto. But what about manufacturing costs like factory rent? Such
costs do not change from month to month, whereas the number and variety of products
made in the factory may vary dramatically from one month to the next. Because these
costs remain unchanged from month to month regardless of what products are made,
they are clearly not caused by—and cannot be directly traced to—any particular product. Therefore, these types of costs are assigned to products and services by averaging
across time and across products. The type of production process influences how this
averaging is done.
Job-order costing is used in situations where many different products, each
with individual and unique features, are produced each period. For example, a Levi
Strauss clothing factory would typically make many different types of jeans for both
men and women during a month. A particular order might consist of 1,000 boot-cut
men’s blue denim jeans, style number A312. This order of 1,000 jeans is called a
job. In a job-order costing system, costs are traced and allocated to jobs and then the
costs of the job are divided by the number of units in the job to arrive at an average
cost per unit.
Other examples of situations where job-order costing would be used include
large-scale construction projects managed by Bechtel International, commercial aircraft produced by Boeing, greeting cards designed and printed by Hallmark, and
airline meals prepared by LSG SkyChefs. All of these examples are characterized by
diverse outputs. Each Bechtel project is unique and different from every other—the
company may be simultaneously constructing a dam in Nigeria and a bridge in Indonesia. Likewise, each airline orders a different type of meal from LSG SkyChefs’
catering service.
Job-order costing is also used extensively in service industries. For example, hospitals, law firms, movie studios, accounting firms, advertising agencies, and repair
shops all use a variation of job-order costing to accumulate costs. Although the detailed
example of job-order costing provided in the following section deals with a manufacturing company, the same basic concepts and procedures are used by many service
organizations.
Job-Order Costing
85
IN BUSINESS
IS THIS REALLY A JOB?
VBT Bicycling Vacations of Bristol, Vermont, offers deluxe bicycling vacations in the United States,
Canada, Europe, and other locations throughout the world. For example, the company offers a
10-day tour of the Puglia region of Italy—the “heel of the boot.” The tour price includes international
airfare, 10 nights of lodging, most meals, use of a bicycle, and ground transportation as needed.
Each tour is led by at least two local tour leaders, one of whom rides with the guests along the
tour route. The other tour leader drives a “sag wagon” that carries extra water, snacks, and bicycle
repair equipment and is available for a shuttle back to the hotel or up a hill. The sag wagon also
transports guests’ luggage from one hotel to another.
Each specific tour can be considered a job. For example, Giuliano Astore and Debora Trippetti,
two natives of Puglia, led a VBT tour with 17 guests over 10 days in late April. At the end of the tour,
Giuliano submitted a report, a sort of job cost sheet, to VBT headquarters. This report detailed the
on the ground expenses incurred for this specific tour, including fuel and operating costs for the van,
lodging costs for the guests, the costs of meals provided to guests, the costs of snacks, the cost of
hiring additional ground transportation as needed, and the wages of the tour leaders. In addition to
these costs, some costs are paid directly by VBT in Vermont to vendors. The total cost incurred for
the tour is then compared to the total revenue collected from guests to determine the gross profit
for the tour.
Sources: Giuliano Astore and Gregg Marston, President, VBT Bicycling Vacations. For more information about
VBT, see www.vbt.com.
Job-Order Costing—An Example
To introduce job-order costing, we will follow a specific job as it progresses through the
manufacturing process. This job consists of two experimental couplings that Yost Precision Machining has agreed to produce for Loops Unlimited, a manufacturer of roller
coasters. Couplings connect the cars on the roller coaster and are a critical component in
the performance and safety of the ride. Before we begin our discussion, recall from the
previous chapter that companies generally classify manufacturing costs into three broad
categories: (1) direct materials, (2) direct labor, and (3) manufacturing overhead. As we
study the operation of a job-order costing system, we will see how each of these three
types of costs is recorded and accumulated.
Yost Precision Machining is a small company in Michigan that specializes in fabricating precision metal parts that are used in a variety of applications ranging from deepsea exploration vehicles to the inertial triggers in automobile air bags. The company’s
top managers gather every morning at 8:00 a.m. in the company’s conference room for
the daily planning meeting. Attending the meeting this morning are: Jean Yost, the company’s president; David Cheung, the marketing manager; Debbie Turner, the production
manager; and Marc White, the company controller. The president opened the meeting:
Jean: The production schedule indicates we’ll be starting Job 2B47 today. Isn’t that the
special order for experimental couplings, David?
David: That’s right. That’s the order from Loops Unlimited for two couplings for their
new roller coaster ride for Magic Mountain.
Debbie: Why only two couplings? Don’t they need a coupling for every car?
David: Yes. But this is a completely new roller coaster. The cars will go faster and will
be subjected to more twists, turns, drops, and loops than on any other existing roller
coaster. To hold up under these stresses, Loops Unlimited’s engineers completely
redesigned the cars and couplings. They want us to make just two of these new couplings for testing purposes. If the design works, then we’ll have the inside track on
the order to supply couplings for the whole ride.
MANAGERIAL
ACCOUNTING IN ACTION
THE ISSUE
86
Chapter 3
EXHIBIT 3–1
Materials Requisition Form
Materials Requistion Number
Job Number to Be Charged
Department
14873
Date
March 2
2B47
Milling
Description
M46 Housing
G7 Connector
Quantity
2
4
Unit Cost
$124
$103
Total Cost
$248
412
$660
Jean: We agreed to take on this initial order at our cost just to get our foot in the door.
Marc, will there be any problem documenting our cost so we can get paid?
Marc: No problem. The contract with Loops stipulates that they will pay us an amount
equal to our cost of goods sold. With our job-order costing system, I can tell you the
cost on the day the job is completed.
Jean: Good. Is there anything else we should discuss about this job at this time? No?
Well then let’s move on to the next item of business.
Measuring Direct Materials Cost
The blueprints submitted by Loops Unlimited indicate that each experimental coupling
will require three parts that are classified as direct materials: two G7 Connectors and one
M46 Housing. Since each coupling requires two connectors and one housing, the production of two couplings requires four connectors and two housings. This is a custom product that is being made for the first time, but if this were one of the company’s standard
products, it would have an established bill of materials. A bill of materials is a document
that lists the type and quantity of each type of direct material needed to complete a unit
of product.
When an agreement has been reached with the customer concerning the quantities,
prices, and shipment date for the order, a production order is issued. The Production
Department then prepares a materials requisition form similar to the form in Exhibit 3–1.
The materials requisition form is a document that specifies the type and quantity of
materials to be drawn from the storeroom and identifies the job that will be charged for
the cost of the materials. The form is used to control the flow of materials into production
and also for making entries in the accounting records.
The Yost Precision Machining materials requisition form in Exhibit 3–1 shows that
the company’s Milling Department has requisitioned two M46 Housings and four G7
Connectors for the Loops Unlimited job, which has been designated as Job 2B47.
Job Cost Sheet
After a production order has been issued, the Accounting Department’s job-order costing software system automatically generates a job cost sheet like the one presented in
Exhibit 3–2. A job cost sheet records the materials, labor, and manufacturing overhead
costs charged to that job.
Job-Order Costing
87
IN BUSINESS
SUPPLY AND DEMAND INFLUENCE LUMBER PRICES
When the housing market crumbled between 2005 and 2009, lumber mills responded by slashing
output by 45%. However, in 2010 many home builders decided to expand speculative construction on the belief that an expiring federal tax credit would entice more customers to purchase new
homes. The result of plummeting supply coupled with an uptick in demand was predictable—the
price of lumber spiked to $279 per thousand board feet, thereby adding about $1,000 to the price
of a typical new home. Pulte Homes told investors that it would attempt to offset the increase in
direct materials cost by reducing its labor costs.
Home builders use job-order costing systems to accumulate the costs incurred to build each
new home. When materials and labor costs fluctuate, job-order costing systems can measure these
impacts on each customer’s new home construction costs.
Source: Liam Pleven and Lester Aldrich, “Builders Nailed by Lumber Prices,” The Wall Street Journal, February
16, 2010, pp. C1 and C4.
After direct materials are issued, the cost of these materials are automatically
recorded on the job cost sheet. Note from Exhibit 3–2, for example, that the $660 cost for
direct materials shown earlier on the materials requisition form has been charged to Job
2B47 on its job cost sheet. The requisition number 14873 from the materials requisition
form appears on the job cost sheet to make it easier to identify the source document for
the direct materials charge.
EXHIBIT 3–2
Job Cost Sheet
JOB COST SHEET
March 2
Job Number
2B47
Date Initiated
Department
Milling
Date Completed
Item
Special order coupling
Units Completed
For Stock
Direct Materials
Req. No. Amount
14873
$660
Ticket
843
Cost Summary
Direct Materials
Direct Labor
Manufacturing Overhead
Total Product Cost
Unit Product Cost
Direct Labor
Hours
Amount
5
$45
Manufacturing Overhead
Hours
Rate
Amount
Units Shipped
$
$
$
$
$
Date
Number
Balance
88
Chapter 3
Measuring Direct Labor Cost
Direct labor consists of labor charges that are easily traced to a particular job. Labor
charges that cannot be easily traced directly to any job are treated as part of manufacturing overhead. As discussed in the previous chapter, this latter category of labor costs is
called indirect labor and includes tasks such as maintenance, supervision, and cleanup.
Most companies rely on computerized systems to maintain employee time tickets. A
completed time ticket is an hour-by-hour summary of the employee’s activities throughout the day. One computerized approach to creating time tickets uses bar codes to capture
data. Each employee and each job has a unique bar code. When beginning work on a
job, the employee scans three bar codes using a handheld device much like the bar code
readers at grocery store checkout stands. The first bar code indicates that a job is being
started; the second is the unique bar code on the employee’s identity badge; and the third
is the unique bar code of the job itself. This information is fed automatically via an electronic network to a computer that notes the time and records all of the data. When the
task is completed, the employee scans a bar code indicating the task is complete, the bar
code on his or her identity badge, and the bar code attached to the job. This information
is relayed to the computer that again notes the time, and a time ticket, such as the one
shown in Exhibit 3–3, is automatically prepared. Because all of the source data is already
in computer files, the labor costs can be automatically posted to job cost sheets. For
example, Exhibit 3–3 shows $45 of direct labor cost related to Job 2B47. This amount
is automatically posted to the job cost sheet shown in Exhibit 3–2. The time ticket in
Exhibit 3–3 also shows $9 of indirect labor costs related to performing maintenance.
This cost is treated as part of manufacturing overhead and does not get posted on a job
cost sheet.
LO3–1
Computing Predetermined Overhead Rates
Compute a predetermined
overhead rate.
Recall that product costs include manufacturing overhead as well as direct materials and
direct labor. Therefore, manufacturing overhead also needs to be recorded on the job cost
sheet. However, assigning manufacturing overhead to a specific job involves some difficulties. There are three reasons for this:
1. Manufacturing overhead is an indirect cost. This means that it is either impossible or
difficult to trace these costs to a particular product or job.
2. Manufacturing overhead consists of many different types of costs ranging from the
grease used in machines to the annual salary of the production manager. Some of
these costs are variable overhead costs because they vary in direct proportion to
changes in the level of production (e.g., indirect materials, supplies, and power) and
EXHIBIT 3–3
Employee Time Ticket
Time Ticket No.
843
Date
March 3
Employee
Mary Holden
Station
4
Started
7:00
12:30
2:30
Totals
Ended
12:00
2:30
3:30
Time
Completed
5.0
2.0
1.0
8.0
Rate
$9
9
9
Amount
$45
18
9
$72
Job Number
2B47
2B50
Maintenance
Job-Order Costing
89
some are fixed overhead costs because they remain constant as the level of production fluctuates (e.g., heat and light, property taxes, and insurance).
3. Because of the fixed costs in manufacturing overhead, total manufacturing overhead
costs tend to remain relatively constant from one period to the next even though the
number of units produced can fluctuate widely. Consequently, the average cost per
unit will vary from one period to the next.
Given these problems, allocation is used to assign overhead costs to products. Allocation is accomplished by selecting an allocation base that is common to all of the company’s
products and services. An allocation base is a measure such as direct labor-hours (DLH)
or machine-hours (MH) that is used to assign overhead costs to products and services. The
most widely used allocation bases in manufacturing are direct labor-hours, direct labor
cost, machine-hours, and (where a company has only a single product) units of product.
Manufacturing overhead is commonly assigned to products using a predetermined
overhead rate. The predetermined overhead rate is computed by dividing the total estimated manufacturing overhead cost for the period by the estimated total amount of the
allocation base as follows:
Estimated total manufacturing overhead cost
Predetermined overhead rate 5 _______________________________
Estimated total amount of the allocation base
The predetermined overhead rate is computed before the period begins using a four-step
process. The first step is to estimate the total amount of the allocation base (the denominator) that will be required for next period’s estimated level of production. The second
step is to estimate the total fixed manufacturing overhead cost for the coming period and
the variable manufacturing overhead cost per unit of the allocation base. The third step
is to use the cost formula shown below to estimate the total manufacturing overhead cost
(the numerator) for the coming period:
Y 5 a 1 bX
where,
Y 5 The estimated total manufacturing overhead cost
a 5 The estimated total fixed manufacturing overhead cost
b 5 The estimated variable manufacturing overhead cost per unit of the
allocation base
X 5 The estimated total amount of the allocation base
The fourth step is to compute the predetermined overhead rate. Notice, the estimated
amount of the allocation base is determined before estimating the total manufacturing
overhead cost. This needs to be done because total manufacturing overhead cost includes
variable overhead costs that depend on the amount of the allocation base.
Applying Manufacturing Overhead
To repeat, the predetermined overhead rate is computed before the period begins. The
predetermined overhead rate is then used to apply overhead cost to jobs throughout the
period. The process of assigning overhead cost to jobs is called overhead application.
The formula for determining the amount of overhead cost to apply to a particular job is:
Overhead applied to Predetermined Amount of the allocation
5
3
a particular job
overhead rate
base incurred by the job
For example, if the predetermined overhead rate is $8 per direct labor-hour, then $8 of
overhead cost is applied to a job for each direct labor-hour incurred on the job. When the
allocation base is direct labor-hours, the formula becomes:
Actual direct labor-hours
Overhead applied to Predetermined _____________________
5
3
a particular job
overhead rate
charged to the job
LO3–2
Apply overhead cost to
jobs using a predetermined
overhead rate.
90
Chapter 3
Manufacturing Overhead—A Closer Look
To illustrate the steps involved in computing and using a predetermined overhead rate,
let’s return to Yost Precision Machining and make the following assumptions. In step
one, the company estimated that 40,000 direct labor-hours would be required to support
the production planned for the year. In step two, it estimated $220,000 of total fixed
manufacturing overhead cost for the coming year and $2.50 of variable manufacturing
overhead cost per direct labor-hour. Given these assumptions, in step three the company
used the cost formula shown below to estimate its total manufacturing overhead cost for
the year:
Y 5 a 1 bX
Y 5 $220,000 1 ($2.50 per direct labor-hour 3 40,000 direct labor-hours)
Y 5 $220,000 1 $100,000
Y 5 $320,000
In step four, Yost Precision Machining computed its predetermined overhead rate for
the year of $8 per direct labor-hour as shown below:
Estimated total manufacturing overhead cost
Predetermined overhead rate 5 _____________________________________
Estimated total amount of the allocation base
$320,000
5 _____________________
40,000 direct labor-hours
5 $8 per direct labor-hour
The job cost sheet in Exhibit 3–4 indicates that 27 direct labor-hours (i.e., DLHs)
were charged to Job 2B47. Therefore, a total of $216 of manufacturing overhead cost
would be applied to the job:
Overhead applied to Predetermined Actual direct labor-hours
5
3
Job 2B47
overhead rate
charged to Job 2B47
5 $8 per DLH 3 27 DLHs
5 $216 of overhead applied to Job 2B47
This amount of overhead has been entered on the job cost sheet in Exhibit 3–4. Note that
this is not the actual amount of overhead caused by the job. Actual overhead costs are not
assigned to jobs—if that could be done, the costs would be direct costs, not overhead. The
overhead assigned to the job is simply a share of the total overhead that was estimated at
the beginning of the year. A normal cost system, which we have been describing, applies
overhead to jobs by multiplying a predetermined overhead rate by the actual amount of
the allocation base incurred by the jobs.
The Need for a Predetermined Rate
Instead of using a predetermined rate based on estimates, why not base the overhead rate
on the actual total manufacturing overhead cost and the actual total amount of the allocation base incurred on a monthly, quarterly, or annual basis? If an actual rate is computed
monthly or quarterly, seasonal factors in overhead costs or in the allocation base can
produce fluctuations in the overhead rate. For example, the costs of heating and cooling a factory in Illinois will be highest in the winter and summer months and lowest in
the spring and fall. If the overhead rate is recomputed at the end of each month or each
quarter based on actual costs and activity, the overhead rate would go up in the winter and
summer and down in the spring and fall. As a result, two identical jobs, one completed
in the winter and one completed in the spring, would be assigned different manufacturing overhead costs. Many managers believe that such fluctuations in product costs serve
Job-Order Costing
EXHIBIT 3–4
A Completed Job Cost Sheet
JOB COST SHEET
Job Number
2B47
Date Initiated
March 2
Department
Milling
Date Completed
March 8
Item
Special order coupling
For Stock
Units Completed
Direct Materials
Req. No.
Amount
14873
14875
14912
91
$ 660
506
238
$1,404
Ticket
843
846
850
851
Direct Labor
Hours
Amount
$ 45
5
60
8
21
4
54
10
$180
27
Cost Summary
Direct Materials
Direct Labor
Manufacturing Overhead
Total Product Cost
Unit Product Cost
2
Manufacturing Overhead
Hours
Rate
Amount
27
$8/DLH
$216
Units Shipped
$ 1,404
$ 180
$ 216
$ 1,800
$ 900*
Date
March 8
Number
—
Balance
2
*$1,800 4 2 units 5 $900 per unit.
no useful purpose. To avoid such fluctuations, actual overhead rates could be computed
on an annual or less-frequent basis. However, if the overhead rate is computed annually
based on the actual costs and activity for the year, the manufacturing overhead assigned
to any particular job would not be known until the end of the year. For example, the cost
of Job 2B47 at Yost Precision Machining would not be known until the end of the year,
even though the job will be completed and shipped to the customer in March. For these
reasons, most companies use predetermined overhead rates rather than actual overhead
rates in their cost accounting systems.
Choice of an Allocation Base for Overhead Cost
Ideally, the allocation base in the predetermined overhead rate should drive the overhead
cost. A cost driver is a factor, such as machine-hours, beds occupied, computer time, or
flight-hours, that causes overhead costs. If the base in the predetermined overhead rate
does not “drive” overhead costs, product costs will be distorted. For example, if direct
labor-hours is used to allocate overhead, but in reality overhead has little to do with direct
labor-hours, then products with high direct labor-hour requirements will be overcosted.
Most companies use direct labor-hours or direct labor cost as the allocation base
for manufacturing overhead. In the past, direct labor accounted for up to 60% of the
cost of many products, with overhead cost making up only a portion of the remainder.
This situation has changed for two reasons. First, sophisticated automated equipment
has taken over functions that used to be performed by direct labor workers. Because
the costs of acquiring and maintaining such equipment are classified as overhead, this
increases overhead while decreasing direct labor. Second, products are becoming more
92
Chapter 3
sophisticated and complex and are changed more frequently. This increases the need for
highly skilled indirect workers such as engineers. As a result of these two trends, direct
labor has decreased relative to overhead as a component of product costs.
In companies where direct labor and overhead costs have been moving in opposite
directions, it would be difficult to argue that direct labor “drives” overhead costs. Accordingly, managers in some companies use activity-based costing principles to redesign their
cost accounting systems. Activity-based costing is designed to more accurately reflect the
demands that products, customers, and other cost objects make on overhead resources.
The activity-based approach is discussed in more detail in Appendix 3A and in Chapter 7.
Although direct labor may not be an appropriate allocation base in some industries,
in others it continues to be a significant driver of manufacturing overhead. Indeed, most
manufacturing companies in the United States continue to use direct labor as the primary
or secondary allocation base for manufacturing overhead. The key point is that the allocation base used by the company should really drive, or cause, overhead costs, and direct
labor is not always the most appropriate allocation base.
IN BUSINESS
REDUCING HEALTH-DAMAGING BEHAVIORS
Cianbro is an industrial construction company headquartered in Pittsfield, Maine, whose goal is “To be
the healthiest company in America.” It introduced a corporate wellness program to attack employee
behaviors that drive up health-care costs. The table below summarizes the number of employees in
five health risk categories as of 2003 and 2005. The decreases in the number of employees in these
high-risk categories are evidence that the wellness program was effective in helping employees
make positive lifestyle changes. This should result in reduced health-care costs for the company.
Number of Employees
Health Risk Category
January 2003
Obesity . . . . . . . . . . . . . . . .
High cholesterol . . . . . . . . .
Tobacco use . . . . . . . . . . . . .
Inactivity . . . . . . . . . . . . . . .
High blood pressure . . . . . . .
432
637
384
354
139
March 2005
353
515
274
254
91
Decrease
79
122
110
100
48
Source: Cianbro, WELCOA’s Absolute Advantage Magazine, 2006.
LO3–3
Computation of Unit Costs
Compute the total cost and
average cost per unit of a job.
With the application of Yost Precision Machining’s $216 of manufacturing overhead to
the job cost sheet in Exhibit 3–4, the job cost sheet is complete except for two final steps.
First, the totals for direct materials, direct labor, and manufacturing overhead are transferred to the Cost Summary section of the job cost sheet and added together to obtain the
total cost for the job.1 Then the total product cost ($1,800) is divided by the number of
units (2) to obtain the unit product cost ($900). This unit product cost information is used
for valuing unsold units in ending inventory and for determining cost of goods sold. As
indicated earlier, this unit product cost is an average cost and should not be interpreted
as the cost that would actually be incurred if another unit were produced. The incremental cost of an additional unit is something less than the average unit cost of $900 because
much of the actual overhead costs would not change if another unit were produced.
1
Notice, we are assuming that Job 2B47 required direct materials and direct labor beyond the charges
shown in Exhibits 3–1 and 3–3.
Job-Order Costing
In the 8:00 a.m. daily planning meeting on March 9, Jean Yost, the president of Yost Precision Machining, once again drew attention to Job 2B47, the experimental couplings:
93
MANAGERIAL
ACCOUNTING IN ACTION
Jean: I see Job 2B47 is completed. Let’s get those couplings shipped immediately to
Loops Unlimited so they can get their testing program under way. Marc, how much
are we going to bill Loops for those two units?
Marc: Because we agreed to sell the experimental couplings at cost, we will be charging Loops Unlimited just $900 a unit.
Jean: Fine. Let’s hope the couplings work out and we make some money on the big
order later.
THE WRAP-UP
IN BUSINESS
ONE-OF-A-KIND MASTERPIECE
In a true job-order costing environment, every job is unique. For example, Purdey manufactures
80–90 shotguns per year with each gun being a specially commissioned one-of-a-kind masterpiece.
The prices start at $110,000 because every detail is custom built, engraved, assembled, and
polished by a skilled craftsman. The hand engraving can take months to complete and may add as
much as $100,000 to the price. The guns are designed to shoot perfectly straight and their value
increases over time even with heavy use. One Purdey gun collector said “when I shoot my Purdeys
I feel like an orchestra conductor waving my baton.”
Source: Eric Arnold, “Aim High,” Forbes, December 28, 2009, p. 86.
Job-Order Costing—The Flow of Costs
We are now ready to discuss the flow of costs through a job-order costing system.
Exhibit 3–5 provides a conceptual overview of these cost flows. It highlights the fact that
product costs flow through inventories on the balance sheet and then on to cost of goods
sold in the income statement. More specifically, raw materials purchases are recorded in
the Raw Materials inventory account. Raw materials include any materials that go into
the final product. When raw materials are used in production, their costs are transferred
to the Work in Process inventory account as direct materials.2 Work in process consists
of units of product that are only partially complete and will require further work before
they are ready for sale to the customer. Notice that direct labor costs are added directly
to Work in Process—they do not flow through Raw Materials inventory. Manufacturing
overhead costs are applied to Work in Process by multiplying the predetermined overhead
rate by the actual quantity of the allocation base consumed by each job.3 When goods are
completed, their costs are transferred from Work in Process to Finished Goods. Finished
goods consist of completed units of product that have not yet been sold to customers.
The amount transferred from Work in Process to Finished Goods is referred to as the cost
of goods manufactured. The cost of goods manufactured includes the manufacturing
costs associated with the goods that were finished during the period. As goods are sold,
their costs are transferred from Finished Goods to Cost of Goods Sold. At this point, the
various costs required to make the product are finally recorded as an expense. Until that
point, these costs are in inventory accounts on the balance sheet. Period costs (or selling
and administrative expenses) do not flow through inventories on the balance sheet. They
are recorded as expenses on the income statement in the period incurred.
2
Indirect material costs are accounted for as part of manufacturing overhead.
For simplicity, Exhibit 3–5 assumes that Cost of Goods Sold does not need to be adjusted as discussed
later in the chapter.
3
LO3–4
Understand the flow of costs
in a job-order costing system
and prepare appropriate journal
entries to record costs.
94
Chapter 3
EXHIBIT 3–5
Cost Flows and Classifications in a Manufacturing Company
Costs
Balance Sheet
Product costs
Raw materials
purchases
Raw Materials inventory
Direct materials
used in production
Direct labor
Manufacturing
overhead
Work in Process inventory
Goods completed
(Cost of Goods
Manufactured)
Income Statement
Cost of Goods Sold
Finished Goods inventory
Period
costs
Goods
sold
Selling and
administrative
Selling and
Administrative
Expenses
To illustrate the cost flows through a company’s general ledger, we will consider a
single month’s activity at Ruger Corporation, a producer of gold and silver commemorative medallions. Ruger Corporation has two jobs in process during April, the first month
of its fiscal year. Job A, a special minting of 1,000 gold medallions commemorating the
invention of motion pictures, was started during March. By the end of March, $30,000
in manufacturing costs had been recorded for the job. Job B, an order for 10,000 silver
medallions commemorating the fall of the Berlin Wall, was started in April.
The Purchase and Issue of Materials
On April 1, Ruger Corporation had $7,000 in raw materials on hand. During the month,
the company purchased on account an additional $60,000 in raw materials. The purchase
is recorded in journal entry (1) below:
(1)
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60,000
Remember that Raw Materials is an asset account. Thus, when raw materials are
purchased, they are initially recorded as an asset—not as an expense.
Issue of Direct and Indirect Materials During April, $52,000 in raw materials were requisitioned from the storeroom for use in production. These raw materials
included $50,000 of direct and $2,000 of indirect materials. Entry (2) records issuing the
materials to the production departments.
(2)
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
52,000
Job-Order Costing
95
The materials charged to Work in Process represent direct materials for specific jobs.
These costs are also recorded on the appropriate job cost sheets. This point is illustrated
in Exhibit 3–6, where $28,000 of the $50,000 in direct materials is charged to Job A’s cost
sheet and the remaining $22,000 is charged to Job B’s cost sheet. (In this example, all
data are presented in summary form and the job cost sheet is abbreviated.)
The $2,000 charged to Manufacturing Overhead in entry (2) represents indirect
materials. Observe that the Manufacturing Overhead account is separate from the Work
in Process account. The purpose of the Manufacturing Overhead account is to accumulate
all manufacturing overhead costs as they are incurred during a period.
Before leaving Exhibit 3–6, we need to point out one additional thing. Notice from
the exhibit that the job cost sheet for Job A contains a beginning balance of $30,000. We
stated earlier that this balance represents the cost of work done during March that has
been carried forward to April. Also note that the Work in Process account contains the
same $30,000 balance. Thus, the Work in Process account summarizes all of the costs
appearing on the job cost sheets of the jobs that are in process. Job A was the only job
in process at the beginning of April, so the beginning balance in the Work in Process
account equals Job A’s beginning balance of $30,000.
Labor Cost
In April, the employee time tickets included $60,000 recorded for direct labor and
$15,000 for indirect labor. The following entry summarizes these costs:
(3)
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . .
75,000
Only the direct labor cost of $60,000 is added to the Work in Process account. At the
same time that direct labor costs are added to Work in Process, they are also added to the
individual job cost sheets, as shown in Exhibit 3–7. During April, $40,000 of direct labor
cost was charged to Job A and the remaining $20,000 was charged to Job B.
The labor costs charged to Manufacturing Overhead ($15,000) represent the indirect
labor costs of the period, such as supervision, janitorial work, and maintenance.
EXHIBIT 3–6
Raw Materials Cost Flows
Work in Process
Raw Materials
Bal. 7,000 (2) 52,000
(1) 60,000
Manufacturing Overhead
Bal. 30,000
(2) 50,000
Job Cost Sheet
Job A
Balance. . . . . . . . . . $30,000
Direct materials. . . $28,000
(2) 2,000
Job Cost Sheet
Job B
Balance. . . . . . . . . .
$0
Direct materials. . . $22,000
Indirect
materials
Materials Requisition Forms
$52,000
Direct
materials
96
Chapter 3
EXHIBIT 3–7
Labor Cost Flows
Salaries and Wages Payable
(3) 75,000
Work in Process
Manufacturing Overhead
(2) 2,000
(3) 15,000
Bal. 30,000
(2) 50,000
(3) 60,000
Job Cost Sheet
Job A
Balance. . . . . . . . . . $30,000
Direct materials. . . $28,000
Direct labor. . . . . . . $40,000
Job Cost Sheet
Job B
Balance. . . . . . . . . .
$0
Direct materials. . . $22,000
Direct labor. . . . . . . $20,000
Indirect
labor
Various Time Tickets
$75,000
Direct
labor
Manufacturing Overhead Costs
Recall that all manufacturing costs other than direct materials and direct labor are classified as manufacturing overhead costs. These costs are entered directly into the Manufacturing Overhead account as they are incurred. To illustrate, assume that Ruger Corporation
incurred the following general factory costs during April:
Utilities (heat, water, and power) . . . . . . . . . . .
Rent on factory equipment . . . . . . . . . . . . . . . .
Miscellaneous factory overhead costs . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$21,000
16,000
3,000
$40,000
The following entry records the incurrence of these costs:
(4)
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Accounts Payable* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
40,000
*Accounts such as Cash may also be credited
In addition, assume that during April, Ruger Corporation recognized $13,000 in
accrued property taxes and that $7,000 in prepaid insurance expired on factory buildings
and equipment. The following entry records these items:
(5)
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Property Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
13,000
Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7,000
Finally, assume that the company recognized $18,000 in depreciation on factory
equipment during April. The following entry records the accrual of this depreciation:
(6)
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . .
18,000
Job-Order Costing
In short, all actual manufacturing overhead costs are debited to the Manufacturing
Overhead account as they are incurred.
Applying Manufacturing Overhead
Because actual manufacturing costs are charged to the Manufacturing Overhead control
account rather than to Work in Process, how are manufacturing overhead costs assigned
to Work in Process? The answer is, by means of the predetermined overhead rate. Recall
from our discussion earlier in the chapter that a predetermined overhead rate is established at the beginning of each year. The rate is calculated by dividing the estimated total
manufacturing overhead cost for the year by the estimated total amount of the allocation
base (measured in machine-hours, direct labor-hours, or some other base). The predetermined overhead rate is then used to apply overhead costs to jobs. For example, if
machine-hours is the allocation base, overhead cost is applied to each job by multiplying
the predetermined overhead rate by the number of machine-hours charged to the job.
To illustrate, assume that Ruger Corporation’s predetermined overhead rate is $6 per
machine-hour. Also assume that during April, 10,000 machine-hours were worked on Job
A and 5,000 machine-hours were worked on Job B (a total of 15,000 machine-hours). Thus,
$90,000 in overhead cost ($6 per machine-hour 3 15,000 machine-hours 5 $90,000)
would be applied to Work in Process. The following entry records the application of Manufacturing Overhead to Work in Process:
(7)
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . .
90,000
The flow of costs through the Manufacturing Overhead account is shown in Exhibit 3–8.
The actual overhead costs on the debit side in the Manufacturing Overhead account in
Exhibit 3–8 are the costs that were added to the account in entries (2)–(6). Observe that
recording these actual overhead costs [entries (2)–(6)] and the application of overhead to
Work in Process [entry (7)] represent two separate and entirely distinct processes.
The Concept of a Clearing Account The Manufacturing Overhead account
operates as a clearing account. As we have noted, actual factory overhead costs are debited to the account as they are incurred throughout the year. When a job is completed (or
at the end of an accounting period), overhead cost is applied to the job using the predetermined overhead rate, and Work in Process is debited and Manufacturing Overhead is
credited. This sequence of events is illustrated below:
Manufacturing Overhead
(a clearing account)
Actual overhead costs are charged
to this account as they are incurred
throughout the period.
Overhead is applied to Work in Process
using the predetermined overhead rate.
As we emphasized earlier, the predetermined overhead rate is based entirely on estimates of what the level of activity and overhead costs are expected to be, and it is established before the year begins. As a result, the overhead cost applied during a year will
almost certainly turn out to be more or less than the actual overhead cost incurred. For
example, notice from Exhibit 3–8 that Ruger Corporation’s actual overhead costs for the
period are $5,000 greater than the overhead cost that has been applied to Work in Process, resulting in a $5,000 debit balance in the Manufacturing Overhead account. We will
reserve discussion of what to do with this $5,000 balance until later in the chapter.
For the moment, we can conclude from Exhibit 3–8 that the cost of a completed job
consists of the actual direct materials cost of the job, the actual direct labor cost of the
job, and the manufacturing overhead cost applied to the job. Pay particular attention to
the following subtle but important point: Actual overhead costs are not charged to jobs;
97
98
EXHIBIT 3–8
The Flow of Costs in Overhead
Application
Chapter 3
Manufacturing Overhead
Work in Process
Bal. 30,000
(2) 50,000
(3) 60,000
(7) 90,000
Actual
overhead
costs
Balance
Job Cost Sheet
Job A
Balance. . . . . . . . . . . . . . . . . . $30,000
Direct materials. . . . . . . . . . . $28,000
Direct labor. . . . . . . . . . . . . . . $40,000
Manufacturing overhead. . . $60,000
Total. . . . . . . . . . . . . . . . . . . . . $158,000
(2)
(3)
(4)
(5)
(6)
2,000 (7)
15,000
40,000
20,000
18,000
95,000
5,000
90,000
Applied
overhead
costs
90,000
Job Cost Sheet
Job B
Balance. . . . . . . . . . . . . . . . . . .
Direct materials. . . . . . . . . . . .
Direct labor. . . . . . . . . . . . . . . .
Manufacturing overhead. . .
Total. . . . . . . . . . . . . . . . . . . . . .
$0
$22,000
$20,000
$30,000
$72,000
Overhead Applied to Work in Process
$6 per machine-hour 3 15,000 machine-hours = $90,000
actual overhead costs do not appear on the job cost sheet nor do they appear in the Work
in Process account. Only the applied overhead cost, based on the predetermined overhead rate, appears on the job cost sheet and in the Work in Process account.
Nonmanufacturing Costs
In addition to manufacturing costs, companies also incur selling and administrative costs.
These costs should be treated as period expenses and charged directly to the income
statement. Nonmanufacturing costs should not go into the Manufacturing Overhead
account. To illustrate the correct treatment of nonmanufacturing costs, assume that Ruger
Corporation incurred $30,000 in selling and administrative salary costs during April. The
following entry summarizes the accrual of those salaries:
(8)
Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . .
30,000
Assume that depreciation on office equipment during April was $7,000. The entry is
as follows:
(9)
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . .
7,000
7,000
Pay particular attention to the difference between this entry and entry (6) where we
recorded depreciation on factory equipment. In journal entry (6), depreciation on factory equipment was debited to Manufacturing Overhead and is therefore a product cost.
In journal entry (9) above, depreciation on office equipment is debited to Depreciation
Expense. Depreciation on office equipment is a period expense rather than a product cost.
Finally, assume that advertising was $42,000 and that other selling and administrative expenses in April totaled $8,000. The following entry records these items:
Job-Order Costing
(10)
Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000
Other Selling and Administrative Expense . . . . . . . . . . . . . . . . 8,000
Accounts Payable* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
50,000
*Other accounts, such as Cash may be credited.
The amounts in entries (8) through (10) are recorded directly into expense accounts—
they have no effect on product costs. The same will be true of any other selling and administrative expenses incurred during April, including sales commissions, depreciation on
sales equipment, rent on office facilities, insurance on office facilities, and related costs.
Cost of Goods Manufactured
When a job has been completed, the finished output is transferred from the production
departments to the finished goods warehouse. By this time, the accounting department
will have charged the job with direct materials and direct labor cost, and manufacturing
overhead will have been applied using the predetermined overhead rate. A transfer of costs
is made within the costing system that parallels the physical transfer of goods to the finished goods warehouse. The costs of the completed job are transferred out of the Work in
Process account and into the Finished Goods account. The sum of all amounts transferred
between these two accounts represents the cost of goods manufactured for the period.
In the case of Ruger Corporation, assume that Job A was completed during April.
The following entry transfers the cost of Job A from Work in Process to Finished Goods:
(11)
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158,000
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
158,000
The $158,000 represents the completed cost of Job A, as shown on the job cost sheet in
Exhibit 3–8. Because Job A was the only job completed during April, the $158,000 also
represents the cost of goods manufactured for the month.
Job B was not completed by the end of the month, so its cost will remain in the Work
in Process account and carry over to the next month. If a balance sheet is prepared at the
end of April, the cost accumulated thus far on Job B will appear as the asset “Work in
Process inventory.”
Cost of Goods Sold
As finished goods are shipped to customers, their accumulated costs are transferred from
the Finished Goods account to the Cost of Goods Sold account. If an entire job is shipped
at one time, then the entire cost appearing on the job cost sheet is transferred to the Cost
of Goods Sold account. In most cases, however, only a portion of the units involved in a
particular job will be immediately sold. In these situations, the unit product cost must be
used to determine how much product cost should be removed from Finished Goods and
charged to Cost of Goods Sold.
For Ruger Corporation, we will assume 750 of the 1,000 gold medallions in Job A
were shipped to customers by the end of the month for total sales revenue of $225,000.
Because 1,000 units were produced and the total cost of the job from the job cost sheet
was $158,000, the unit product cost was $158. The following journal entries would record
the sale (all sales were on account):
(12)
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
225,000
(13)
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118,500
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
118,500
(750 units 3 $158 per unit 5 $118,500) . . . . . . . . . . . . . .
99
100
LO3–5
Use T-accounts to show the
flow of costs in a job-order
costing system.
EXHIBIT 3–9
Summary of Journal Entries—
Ruger Corporation
Chapter 3
Entry (13) completes the flow of costs through the job-order costing system. To pull
the entire Ruger Corporation example together, journal entries (1) through (13) are summarized in Exhibit 3–9. The flow of costs through the accounts is presented in T-account
form in Exhibit 3–10.
(1)
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60,000
(2)
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . .
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
50,000
2,000
(3)
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . .
Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . .
60,000
15,000
(4)
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
40,000
(5)
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60,000
52,000
75,000
40,000
20,000
13,000
7,000
(6)
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . .
18,000
(7)
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . .
90,000
(8)
Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . .
30,000
(9)
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . .
7,000
18,000
90,000
30,000
7,000
(10)
Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other Selling and Administrative Expense . . . . . . . . . . . . . .
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
42,000
8,000
50,000
(11)
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158,000
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
158,000
(12)
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
225,000
(13)
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118,500
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
118,500
Job-Order Costing
101
EXHIBIT 3–10
Summary of Cost Flows—Ruger
Corporation
Accounts Receivable
Bal.
(12)
Accounts Payable
XX
225,000
Bal.
(1)
(4)
(10)
Prepaid Insurance
Bal.
XX
(5)
7,000
7,000
60,000
15,000
(2)
(12)
Bal.
(3)
(8)
52,000
XX
75,000
30,000
Property Taxes Payable
Bal.
(5)
Work in Process
(13)
30,000
50,000
60,000
90,000
72,000
(11)
118,500
Salaries Expense
(8)
30,000
Depreciation Expense
(9)
XX
13,000
7,000
Advertising Expense
(10)
Bal.
(2)
(3)
(7)
Bal.
225,000
Cost of Goods Sold
Salaries and Wages Payable
Raw Materials
Bal.
(1)
Bal.
XX
60,000
40,000
50,000
Sales
42,000
158,000
Other Selling and
Administrative Expense
(10)
8,000
Finished Goods
Bal.
(11)
Bal.
10,000
158,000
49,500
(13)
118,500
Accumulated Depreciation
Bal.
(6)
(9)
XX
18,000
7,000
Manufacturing Overhead
(2)
(3)
(4)
(5)
(6)
Bal.
2,000
15,000
40,000
20,000
18,000
95,000
5,000
(7)
90,000
90,000
Explanation of entries:
(1) Raw materials purchased.
(2) Direct and indirect materials issued into production.
(3) Direct and indirect factory labor cost incurred.
(4) Utilities and other factory costs incurred.
(5) Property taxes and insurance incurred on the factory.
(6) Depreciation recorded on factory assets.
(7) Overhead cost applied to Work in Process.
(8) Administrative salaries expense incurred.
(9) Depreciation recorded on office equipment.
(10) Advertising and other selling and administrative
expense incurred.
(11) Cost of goods manufactured transferred to finished
goods.
(12) Sale of Job A recorded.
(13) Cost of goods sold recorded for Job A.
102
Chapter 3
Schedules of Cost of Goods Manufactured and Cost of Goods Sold
LO3–6
Prepare schedules of cost of
goods manufactured and cost
of goods sold and an income
statement.
This section uses the Ruger Corporation example to explain how to prepare schedules of cost of goods manufactured and cost of goods sold as well as an income statement. The schedule of cost of goods manufactured contains three elements of product
costs—direct materials, direct labor, and manufacturing overhead—and it summarizes
the portions of those costs that remain in ending Work in Process inventory and that are
transferred out of Work in Process into Finished Goods. The schedule of cost of goods
sold also contains three elements of product costs—direct materials, direct labor, and
manufacturing overhead—and it summarizes the portions of those costs that remain in
ending Finished Goods inventory and that are transferred out of Finished Goods into Cost
of Goods Sold.
Exhibit 3–11 presents Ruger Corporation’s schedules of cost of goods manufactured
and cost of goods sold. We want to draw your attention to three equations that are embedded within the schedule of cost of goods manufactured. First, the raw materials used in
production are computed using the following equation:
Raw materials 5 ________________
Purchases of 2 __________________
Beginning raw 1 ___________
Ending raw materials
________________
used in production
materials inventory
raw materials
inventory
For Ruger Corporation, the beginning raw materials inventory of $7,000 plus the purchases of raw materials of $60,000 minus the ending raw materials inventory of $15,000
EXHIBIT 3–11
Schedules of Cost of Goods
Manufactured and Cost of
Goods Sold
Cost of Goods Manufactured
Direct materials:
Beginning raw materials inventory . . . . . . . . . . . . . . . . . .
Add: Purchases of raw materials . . . . . . . . . . . . . . . . . . .
Total raw materials available . . . . . . . . . . . . . . . . . . . . . .
Deduct: Ending raw materials inventory . . . . . . . . . . . . . .
Raw materials used in production . . . . . . . . . . . . . . . . . .
Deduct: Indirect materials included in manufacturing
overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead applied to work in process . . . . . .
Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . . . .
Add: Beginning work in process inventory . . . . . . . . . . . . .
$ 7,000
60,000
67,000
15,000
52,000
2,000
Deduct: Ending work in process inventory . . . . . . . . . . . . .
Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . .
$ 50,000
60,000
90,000
200,000
30,000
230,000
72,000
$158,000
Cost of Goods Sold
Beginning finished goods inventory . . . . . . . . . . . . . . . . . .
Add: Cost of goods manufactured . . . . . . . . . . . . . . . . . . .
Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . .
Deduct: Ending finished goods inventory . . . . . . . . . . . . . .
Unadjusted cost of goods sold . . . . . . . . . . . . . . . . . . . . . .
Add: Underapplied overhead . . . . . . . . . . . . . . . . . . . . . . . .
Adjusted cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . .
$ 10,000
158,000
168,000
49,500
118,500
5,000
$123,500
*Note that the underapplied overhead is added to cost of goods sold. If overhead
were overapplied, it would be deducted from cost of goods sold.
Job-Order Costing
equals the raw materials used in production of $52,000. Second, the total manufacturing
costs are computed using the following equation:
Total
Manufacturing
manufacturing 5 Direct materials 1 Direct labor 1 overhead applied to
costs
work in process
For Ruger Corporation, the direct materials of $50,000 plus the direct labor of
$60,000 plus the manufacturing overhead applied to work in process of $90,000
equals the total manufacturing costs of $200,000. Notice, the direct materials used in
production ($50,000) is included in total manufacturing costs instead of raw materials purchases ($60,000). The direct materials used in production will usually differ
from the amount of raw material purchases when the raw materials inventory balance
changes or indirect materials are withdrawn from raw materials inventory. You should
also make a note that this equation includes manufacturing overhead applied to work
in process rather than actual manufacturing overhead costs. For Ruger Corporation,
its manufacturing overhead applied to work in process of $90,000 is computed by
multiplying the predetermined overhead rate of $6 per machine-hour by the actual
amount of the allocation base recorded on all jobs, or 15,000 machine-hours. The
actual manufacturing overhead costs incurred during the period are not added to the
Work in Process account.
The third equation included in the schedule of cost of goods manufactured relates to
computing the cost of goods manufactured:
Cost of goods
Beginning work in
Ending work in
Total
5
1
2
manufactured manufacturing costs
process inventory process inventory
For Ruger, the total manufacturing costs of $200,000 plus the beginning work in process
inventory of $30,000 minus the ending work in process inventory of $72,000 equals the
cost of goods manufactured of $158,000. The cost of goods manufactured represents the
cost of the goods completed during the period and transferred from Work in Process to
Finished Goods.
The schedule of cost of goods sold shown in Exhibit 3–11 relies on the following
equation to compute the unadjusted cost of goods sold:
Unadjusted cost Beginning finished Cost of goods Ending finished
5
1
2
of goods sold
goods inventory
manufactured goods inventory
The beginning finished goods inventory ($10,000) plus the cost of goods manufactured ($158,000) equals the cost of goods available for sale ($168,000). The cost
of goods available for sale ($168,000) minus the ending finished goods inventory
($49,500) equals the unadjusted cost of goods sold ($118,500). Finally, the unadjusted cost of goods sold ($118,500) plus the underapplied overhead ($5,000) equals
adjusted cost of goods sold ($123,500). The next section of the chapter takes a closer
look at why cost of goods sold needs to be adjusted for the amount of underapplied or
overapplied overhead.
Exhibit 3–12 presents Ruger Corporation’s income statement for April. Observe that
the cost of goods sold on this statement is carried over from Exhibit 3–11. The selling and
administrative expenses (which total $87,000) did not flow through the schedules of cost
of goods manufactured and cost of goods sold. Journal entries 8–10 (pages 98–99) show
that these items were immediately debited to expense accounts rather than being debited
to inventory accounts.
103
104
Chapter 3
EXHIBIT 3–12
Income Statement
Ruger Corporation
Income Statement
For the Month Ending April 30
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold ($118,500 1 $5,000) . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation expense . . . . . . . . . . . . . . . . . . . . .
Advertising expense . . . . . . . . . . . . . . . . . . . . . . .
Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . . . . . . . . . . . . . . .
$225,000
123,500
101,500
$30,000
7,000
42,000
8,000
87,000
$ 14,500
Underapplied and Overapplied Overhead—A Closer Look
LO3–7
Compute underapplied or
overapplied overhead cost
and prepare the journal
entry to close the balance in
Manufacturing Overhead to the
appropriate accounts.
This section explains how to compute underapplied and overapplied overhead and how
to dispose of any balance remaining in the Manufacturing Overhead account at the end
of a period.
Computing Underapplied and Overapplied Overhead
Because the predetermined overhead rate is established before the period begins and is
based entirely on estimated data, the overhead cost applied to Work in Process will generally differ from the amount of overhead cost actually incurred. In the case of Ruger
Corporation, for example, the predetermined overhead rate of $6 per hour was used to
apply $90,000 of overhead cost to Work in Process, whereas actual overhead costs for
April proved to be $95,000 (see Exhibit 3–8). The difference between the overhead cost
applied to Work in Process and the actual overhead costs of a period is called either
underapplied or overapplied overhead. For Ruger Corporation, overhead was underapplied by $5,000 because the applied cost ($90,000) was $5,000 less than the actual cost
($95,000). If the situation had been reversed and the company had applied $95,000 in
overhead cost to Work in Process while incurring actual overhead costs of only $90,000,
then the overhead would have been overapplied.
What is the cause of underapplied or overapplied overhead? Basically, the method of
applying overhead to jobs using a predetermined overhead rate assumes that actual overhead costs will be proportional to the actual amount of the allocation base incurred during
the period. If, for example, the predetermined overhead rate is $6 per machine-hour, then
it is assumed that actual overhead costs incurred will be $6 for every machine-hour that is
actually worked. There are at least two reasons why this may not be true. First, much of
the overhead often consists of fixed costs that do not change as the number of machinehours incurred goes up or down. Second, spending on overhead items may or may not be
under control. If individuals who are responsible for overhead costs do a good job, those
costs should be less than were expected at the beginning of the period. If they do a poor
job, those costs will be more than expected.
To illustrate these concepts, suppose that two companies—Turbo Crafters and
Black & Howell—have prepared the following estimated data for the coming year:
Turbo Crafters
Allocation base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Estimated manufacturing overhead cost (a) . . . . . . . . .
Estimated total amount of the allocation base (b) . . . .
Predetermined overhead rate (a) 4 (b) . . . . . . . . . . . . .
Black & Howell
Machine-hours
Direct materials cost
$300,000
$120,000
75,000 machine-hours
$80,000 direct materials cost
$4 per machine-hour
150% of direct materials cost
Job-Order Costing
105
Note that when the allocation base is dollars (such as direct materials cost in the case
of Black & Howell) the predetermined overhead rate is expressed as a percentage of the
allocation base. When dollars are divided by dollars, the result is a percentage.
Now assume that because of unexpected changes in overhead spending and in
demand for the companies’ products, the actual overhead cost and the actual activity
recorded during the year in each company are as follows:
Turbo Crafters
Actual manufacturing overhead cost . . . . . . . . . . . . . . . .
Actual total amount of the allocation base . . . . . . . . . . . .
$290,000
68,000 machine-hours
Black & Howell
$130,000
$90,000 direct materials cost
For each company, note that the actual data for both cost and the allocation base differ from the estimates used in computing the predetermined overhead rate. This results in
underapplied and overapplied overhead as follows:
Turbo Crafters
Actual manufacturing overhead cost . . . . . . . . . . . . . . . .
Manufacturing overhead cost applied to
Work in Process during the year:
Predetermined overhead rate (a) . . . . . . . . . . . . . . . . . .
Actual total amount of the allocation base (b) . . . . . . . .
Manufacturing overhead applied (a) 3 (b) . . . . . . . . . . .
Underapplied (overapplied) manufacturing overhead . . . .
$290,000
Black & Howell
$130,000
$4 per machine-hour
150% of direct materials cost
68,000 machine-hours
$90,000 direct materials cost
$272,000
$135,000
$18,000
$(5,000)
For Turbo Crafters, the amount of overhead cost applied to Work in Process
($272,000) is less than the actual overhead cost for the year ($290,000). Therefore, overhead is underapplied.
For Black & Howell, the amount of overhead cost applied to Work in Process
($135,000) is greater than the actual overhead cost for the year ($130,000), so overhead
is overapplied.
A summary of these concepts is presented in Exhibit 3–13.
EXHIBIT 3–13
Summary of Overhead Concepts
At the beginning of the period:
Estimated total
manufacturing
overhead cost
4
Estimated total
amount of the
allocation base
5
Predetermined
overhead rate
During the period:
Predetermined
overhead rate
3
Actual total amount of the
allocation base incurred
during the period
5
Total
manufacturing
overhead applied
Total
manufacturing
overhead applied
5
Underapplied
(overapplied)
overhead
At the end of the period:
Actual total
manufacturing
overhead cost
2
106
Chapter 3
Disposition of Underapplied or Overapplied
Overhead Balances
If we return to the Ruger Corporation example and look at the Manufacturing Overhead
T-account in Exhibit 3–10, you will see that there is a debit balance of $5,000. Remember that debit entries to the account represent actual overhead costs incurred, whereas
credit entries represent overhead costs applied to jobs. In this case, the actual overhead
costs incurred exceeded the overhead costs applied to jobs by $5,000—hence, the debit
balance of $5,000. This may sound familiar. We just discussed in the previous section
the fact that the overhead costs incurred ($95,000) exceeded the overhead costs applied
($90,000), and that the difference is called underapplied overhead. These are just two
ways of looking at the same thing. If there is a debit balance in the Manufacturing Overhead account of X dollars, then the overhead is underapplied by X dollars. On the other
hand, if there is a credit balance in the Manufacturing Overhead account of Y dollars,
then the overhead is overapplied by Y dollars. What do we do with the balance in the
Manufacturing Overhead account at the end of the accounting period?
The underapplied or overapplied balance remaining in the Manufacturing Overhead
account at the end of a period is treated in one of two ways:
1. Closed out to Cost of Goods Sold.
2. Allocated among the Work in Process, Finished Goods, and Cost of Goods Sold
accounts in proportion to the overhead applied during the current period in ending
balances.
Closed Out to Cost of Goods Sold Closing out the balance in Manufacturing Overhead to Cost of Goods Sold is simpler than the allocation method. In the Ruger
Corporation example, the entry to close the $5,000 of underapplied overhead to Cost of
Goods Sold is:
(14)
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5,000
Note that because the Manufacturing Overhead account has a debit balance, Manufacturing Overhead must be credited to close out the account. This has the effect of increasing
Cost of Goods Sold for April to $123,500:
Unadjusted cost of goods sold [from entry (13)] . . . . . . .
Add underapplied overhead [from entry (14)] . . . . . . . . . .
Adjusted cost of goods sold . . . . . . . . . . . . . . . . . . . . . .
$118,500
5,000
$123,500
After this adjustment has been made, Ruger Corporation’s income statement for April
will appear as shown earlier in Exhibit 3–12.
Note that this adjustment makes sense. The unadjusted cost of goods sold is based on
the amount of manufacturing overhead applied to jobs, not the manufacturing overhead
costs actually incurred. Because overhead was underapplied, not enough cost was applied
to jobs. Hence, the cost of goods sold was understated. Adding the underapplied overhead
to the cost of goods sold corrects this understatement.
Allocated between Accounts Allocation of underapplied or overapplied overhead between Work in Process, Finished Goods, and Cost of Goods Sold is more accurate
than closing the entire balance into Cost of Goods Sold. This allocation assigns overhead
costs to where they would have gone had the estimates included in the predetermined
overhead rate matched the actual amounts.
Had Ruger Corporation chosen to allocate the underapplied overhead among the
inventory accounts and Cost of Goods Sold, it would first be necessary to determine the
Job-Order Costing
amount of overhead that had been applied during April to each of the accounts. The computations would have been as follows:
Overhead applied in work in process inventory, April 30 (Job B) . . . $30,000 33.33%
Overhead applied in finished goods inventory, April 30
Job A: ($60,000/1,000 units 5 $60 per unit) 3 250 units . . . . . . . 15,000 16.67%
Overhead applied in cost of goods sold, April
Job A: ($60,000/1,000 units 5 $60 per unit) 3 750 units . . . . . . . 45,000 50.00%
Total overhead applied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000 100.00%
Based on the above percentages, the underapplied overhead (i.e., the debit balance in
Manufacturing Overhead) would be allocated as shown in the following journal entry:
Work in Process (33.33% 3 $5,000) . . . . . . . . . . . . . . . . . 1,666.50
Finished Goods (16.67% 3 $5,000) . . . . . . . . . . . . . . . . .
833.50
Cost of Goods Sold (50.00% 3 $5,000) . . . . . . . . . . . . . . 2,500.00
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . .
5,000.00
Note that the first step in the allocation process was to determine the amount of overhead
applied in each of the accounts. For Finished Goods, for example, the total amount of
overhead applied to Job A, $60,000, was divided by the total number of units in Job A,
1,000 units, to arrive at the average overhead applied of $60 per unit. Because 250 units
from Job A were still in ending finished goods inventory, the amount of overhead applied
in the Finished Goods Inventory account was $60 per unit multiplied by 250 units or
$15,000 in total.
If overhead had been overapplied, the entry above would have been just the reverse,
because a credit balance would have existed in the Manufacturing Overhead account.
Which Method Should Be Used for Disposing of Underapplied or Overapplied Overhead?
The allocation method is generally considered more accurate than simply closing out the
underapplied or overapplied overhead to Cost of Goods Sold. However, the allocation
method is more complex. We will always specify which method you are to use in problem assignments.
A General Model of Product Cost Flows
Exhibit 3–14 presents a T-account model of the flow of costs in a product costing system.
This model can be very helpful in understanding how production costs flow through a
costing system and finally end up as Cost of Goods Sold on the income statement.
Multiple Predetermined Overhead Rates
Our discussion in this chapter has assumed that there is a single predetermined overhead
rate for an entire factory called a plantwide overhead rate. This is a fairly common
practice—particularly in smaller companies. But in larger companies, multiple predetermined overhead rates are often used. In a multiple predetermined overhead rate
system each production department may have its own predetermined overhead rate. Such
a system, while more complex, is more accurate because it can reflect differences across
departments in how overhead costs are incurred. For example, in departments that are
relatively labor intensive overhead might be allocated based on direct labor-hours and
in departments that are relatively machine intensive overhead might be allocated based
on machine-hours. When multiple predetermined overhead rates are used, overhead is
applied in each department according to its own overhead rate as jobs proceed through
the department.
107
108
Chapter 3
EXHIBIT 3–14
A General Model of Cost Flows
Raw Materials
Debited for the
cost of materials
purchased
Credited for direct
materials added to
Work in Process
Credited for indirect
materials added to
Manufacturing
Overhead
Salaries and Wages Payable
Credited for direct
labor added to
Work in Process
Work in Process
Debited for the
Credited for the
cost of direct
cost of goods
materials, direct manufactured
labor, and
manufacturing
overhead applied
Credited for indirect labor added
to Manufacturing
Overhead
Manufacturing Overhead
Debited for actual
overhead costs
incurred
Credited for overhead cost applied
to Work in Process
Underapplied
overhead cost
Overapplied
overhead cost
Finished Goods
Debited for the
cost of goods
manufactured
Credited for the
cost of goods
sold
Cost of Goods Sold
Debited for
the cost of
goods sold
Job-Order Costing in Service Companies
Job-order costing is used in service organizations such as law firms, movie studios,
hospitals, and repair shops, as well as in manufacturing companies. In a law firm, for
example, each client is a “job,” and the costs of that job are accumulated day by day
on a job cost sheet as the client’s case is handled by the firm. Legal forms and similar
inputs represent the direct materials for the job; the time expended by attorneys is like
direct labor; and the costs of secretaries and legal aids, rent, depreciation, and so forth,
represent the overhead.
In a movie studio such as Columbia Pictures, each film produced by the studio is a
“job,” and costs of direct materials (costumes, props, film, etc.) and direct labor (actors,
directors, and extras) are charged to each film’s job cost sheet. A share of the studio’s
overhead costs, such as utilities, depreciation of equipment, wages of maintenance workers, and so forth, is also charged to each film.
In sum, job-order costing is a versatile and widely used costing method that may be
encountered in virtually any organization that provides diverse products or services.
Job-Order Costing
109
IN BUSINESS
COMPUTING JOB COSTS AT FAST WRAP
In 2007, Michael Enos founded Fast Wrap, a company that shrink-wraps everything from jet skis and
recreation vehicles (RVs) to entire buildings. Today, the company has 64 locations across America and
generates more than $6 million in annual sales. The company’s revenues far exceed its direct materials and direct labor costs. For example, Fast Wrap charges customers $400 to wrap a 20-foot boat
that requires $25 worth of plastic and $30 worth of labor. Larger jobs are even more profitable. For
example, Fast Wrap signed a $250,000 contract to shrink-wrap a 244,000-square-foot hospital under
construction in Fontana, California. The materials and labor for this job cost Fast Wrap $44,000.
Source: Susan Adams, “It’s a Wrap,” Forbes, March 15, 2010, pp. 36–38.
Summary
Job-order costing is used in situations where the organization offers many different products or services, such as in furniture manufacturing, hospitals, and legal firms. Materials requisition forms and
labor time tickets are used to assign direct materials and direct labor costs to jobs in a job-order
costing system. Manufacturing overhead costs are assigned to jobs using a predetermined overhead
rate. All of the costs are recorded on a job cost sheet. The predetermined overhead rate is determined
before the period begins by dividing the estimated total manufacturing overhead cost for the period
by the estimated total amount of the allocation base for the period. The most frequently used allocation bases are direct labor-hours and machine-hours. Overhead is applied to jobs by multiplying the
predetermined overhead rate by the actual amount of the allocation base recorded for the job.
Because the predetermined overhead rate is based on estimates, the actual overhead cost
incurred during a period may be more or less than the amount of overhead cost applied to production. Such a difference is referred to as underapplied or overapplied overhead. The underapplied or overapplied overhead for a period can be either closed out to Cost of Goods Sold or
allocated between Work in Process, Finished Goods, and Cost of Goods Sold. When overhead is
underapplied, manufacturing overhead costs have been understated and therefore inventories and/
or expenses must be adjusted upwards. When overhead is overapplied, manufacturing overhead
costs have been overstated and therefore inventories and/or expenses must be adjusted downwards.
Review Problem: Job-Order Costing
Hogle Corporation is a manufacturer that uses job-order costing. On January 1, the beginning of its
fiscal year, the company’s inventory balances were as follows:
Raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finished goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$20,000
$15,000
$30,000
The company applies overhead cost to jobs on the basis of machine-hours worked. For the
current year, the company’s predetermined overhead rate was based on a cost formula that estimated $450,000 of total manufacturing overhead for an estimated activity level of 75,000 machinehours. The following transactions were recorded for the year:
a. Raw materials were purchased on account, $410,000.
b. Raw materials were requisitioned for use in production, $380,000 ($360,000 direct materials
and $20,000 indirect materials).
c. The following costs were accrued for employee services: direct labor, $75,000; indirect labor,
$110,000; sales commissions, $90,000; and administrative salaries, $200,000.
d. Sales travel costs were $17,000.
e. Utility costs in the factory were $43,000.
110
Chapter 3
f.
g.
h.
i.
j.
k.
Advertising costs were $180,000.
Depreciation was recorded for the year, $350,000 (80% relates to factory operations, and 20%
relates to selling and administrative activities).
Insurance expired during the year, $10,000 (70% relates to factory operations, and the remaining 30% relates to selling and administrative activities).
Manufacturing overhead was applied to production. Due to greater than expected demand for
its products, the company worked 80,000 machine-hours on all jobs during the year.
Goods costing $900,000 to manufacture according to their job cost sheets were completed
during the year.
Goods were sold on account to customers during the year for a total of $1,500,000. The goods
cost $870,000 to manufacture according to their job cost sheets.
Required:
1.
2.
3.
4.
Prepare journal entries to record the preceding transactions.
Post the entries in (1) above to T-accounts (don’t forget to enter the beginning balances in the
inventory accounts).
Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry
to close any balance in the Manufacturing Overhead account to Cost of Goods Sold. Do not
allocate the balance between ending inventories and Cost of Goods Sold.
Prepare an income statement for the year.
Solution to Review Problem
1.
a.
b.
c.
d.
e.
f.
g.
h.
i.
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
410,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
360,000
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . .
20,000
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
75,000
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . .
110,000
Sales Commissions Expense . . . . . . . . . . . . . . . . . . . . . . .
90,000
Administrative Salaries Expense . . . . . . . . . . . . . . . . . . .
200,000
Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . .
Sales Travel Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .
17,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . .
43,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
180,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . .
280,000
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .
70,000
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . .
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . .
7,000
Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3,000
Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The predetermined overhead rate for the year is computed as follows:
410,000
380,000
475,000
17,000
43,000
180,000
350,000
10,000
Estimated total manufacturing overhead cost
Predetermined 5 _____________________________________
overhead rate
Estimated total amount of the allocation base
$450,000
5 ___________________
75,000 machine-hours
5 $6 per machine-hour
Based on the 80,000 machine-hours actually worked during the year, the company applied
$480,000 in overhead cost to production: $6 per machine-hour 3 80,000 machinehours 5 $480,000. The following entry records this application of overhead cost:
j.
k.
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
480,000
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . .
480,000
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
900,000
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
900,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1,500,000
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
870,000
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
870,000
Job-Order Costing
2.
Accounts Receivable
(k)
Manufacturing Overhead
1,500,000
(b)
(c)
(e)
(g)
(h)
Prepaid Insurance
(h)
10,000
20,000
110,000
43,000
280,000
7,000
(i)
Sales
480,000
(k)
460,000
480,000
Bal.
20,000
410,000
Bal.
50,000
(b)
(k)
15,000
360,000
75,000
480,000
Bal.
30,000
20,000
380,000
Accumulated Depreciation
(g)
(c)
Administrative Salaries Expense
Accounts Payable
( j)
(a)
(d)
(e)
(f)
900,000
Finished Goods
30,000
900,000
Bal.
60,000
90,000
350,000
(c)
410,000
17,000
43,000
180,000
(k)
(c)
200,000
Sales Travel Expense
(d)
Salaries and Wages Payable
Bal.
( j)
870,000
Sales Commissions Expense
Work in Process
Bal.
(b)
(c)
(i)
1,500,000
Cost of Goods Sold
Raw Materials
Bal.
(a)
111
17,000
Advertising Expense
475,000
(f)
180,000
870,000
Depreciation Expense
(g)
70,000
Insurance Expense
(h)
3.
Manufacturing overhead is overapplied for the year. The entry to close it out to Cost of Goods
Sold is as follows:
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of Goods Sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.
20,000
20,000
Hogle Corporation
Income Statement
For the Year Ended December 31
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold ($870,000 2 $20,000) . . . .
$1,500,000
850,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Sales commissions expense . . . . . . . . . . . .
Administrative salaries expense . . . . . . . . . .
Sales travel expense . . . . . . . . . . . . . . . . . . .
Advertising expense . . . . . . . . . . . . . . . . . . .
Depreciation expense . . . . . . . . . . . . . . . . . .
Insurance expense . . . . . . . . . . . . . . . . . . . .
650,000
Net operating income . . . . . . . . . . . . . . . . . . . .
$ 90,000
200,000
17,000
180,000
70,000
3,000
560,000
$
90,000
3,000
112
Chapter 3
Glossary
Absorption costing A costing method that includes all manufacturing costs—direct materials, direct
labor, and both variable and fixed manufacturing overhead—in the cost of a product. (p. 84)
Allocation base A measure of activity such as direct labor-hours or machine-hours that is used to
assign costs to cost objects. (p. 89)
Bill of materials A document that shows the quantity of each type of direct material required to
make a product. (p. 86)
Cost driver A factor, such as machine-hours, beds occupied, computer time, or flight-hours, that
causes overhead costs. (p. 91)
Cost of goods manufactured The manufacturing costs associated with the goods that were finished during the period. (p. 93)
Finished goods Units of product that have been completed but not yet sold to customers. (p. 93)
Job cost sheet A form that records the materials, labor, and manufacturing overhead costs charged
to a job. (p. 86)
Job-order costing A costing system used in situations where many different products, jobs, or
services are produced each period. (p. 84)
Materials requisition form A document that specifies the type and quantity of materials to be
drawn from the storeroom and that identifies the job that will be charged for the cost of those
materials. (p. 86)
Multiple predetermined overhead rates A costing system with multiple overhead cost pools
and a different predetermined overhead rate for each cost pool, rather than a single predetermined overhead rate for the entire company. Each production department may be treated as a
separate overhead cost pool. (p. 107)
Normal cost system A costing system in which overhead costs are applied to a job by multiplying a
predetermined overhead rate by the actual amount of the allocation base incurred by the job. (p. 90)
Overapplied overhead A credit balance in the Manufacturing Overhead account that occurs
when the amount of overhead cost applied to Work in Process exceeds the amount of overhead
cost actually incurred during a period. (p. 104)
Overhead application The process of charging manufacturing overhead cost to job cost sheets
and to the Work in Process account. (p. 89)
Plantwide overhead rate A single predetermined overhead rate that is used throughout a plant. (p. 107)
Predetermined overhead rate A rate used to charge manufacturing overhead cost to jobs that is
established in advance for each period. It is computed by dividing the estimated total manufacturing overhead cost for the period by the estimated total amount of the allocation base for
the period. (p. 89)
Raw materials Any materials that go into the final product. (p. 93)
Schedule of cost of goods manufactured A schedule that contains three elements of product
costs—direct materials, direct labor, and manufacturing overhead—and that summarizes the
portions of those costs that remain in ending Work in Process inventory and that are transferred out of Work in Process into Finished Goods. (p. 102)
Schedule of cost of goods sold A schedule that contains three elements of product costs—direct
materials, direct labor, and manufacturing overhead—and that summarizes the portions of
those costs that remain in ending Finished Goods inventory and that are transferred out of
Finished Goods into Cost of Goods Sold. (p. 102)
Time ticket A document that is used to record the amount of time an employee spends on various
activities. (p. 88)
Underapplied overhead A debit balance in the Manufacturing Overhead account that occurs
when the amount of overhead cost actually incurred exceeds the amount of overhead cost
applied to Work in Process during a period. (p. 104)
Work in process Units of product that are only partially complete and will require further work
before they are ready for sale to the customer. (p. 93)
Questions
3–1
3–2
3–3
Why aren’t actual manufacturing overhead costs traced to jobs just as direct materials
and direct labor costs are traced to jobs?
Explain the four-step process used to compute a predetermined overhead rate.
What is the purpose of the job cost sheet in a job-order costing system?
Job-Order Costing
3–4
3–5
3–6
3–7
3–8
3–9
3–10
3–11
3–12
3–13
113
Explain why some production costs must be assigned to products through an allocation
process.
Why do companies use predetermined overhead rates rather than actual manufacturing
overhead costs to apply overhead to jobs?
What factors should be considered in selecting a base to be used in computing the predetermined overhead rate?
If a company fully allocates all of its overhead costs to jobs, does this guarantee that a
profit will be earned for the period?
What account is credited when overhead cost is applied to Work in Process? Would you
expect the amount applied for a period to equal the actual overhead costs of the period?
Why or why not?
What is underapplied overhead? Overapplied overhead? What disposition is made of
these amounts at the end of the period?
Provide two reasons why overhead might be underapplied in a given year.
What adjustment is made for underapplied overhead on the schedule of cost of goods
sold? What adjustment is made for overapplied overhead?
What is a plantwide overhead rate? Why are multiple overhead rates, rather than a plantwide overhead rate, used in some companies?
What happens to overhead rates based on direct labor when automated equipment
replaces direct labor?
Multiple-choice questions are provided on the text website at www.mhhe.com/garrison15e.
Applying Excel
Available with McGraw-Hill’s Connect® Accounting.
The Excel worksheet form that appears below is to be used to recreate part of the example on
pages 104–105. Download the workbook containing this form from the Online Learning Center at
www.mhhe.com/garrison15e. On the website you will also receive instructions about how to use
this worksheet form.
You should proceed to the requirements below only after completing your worksheet.
LO3–1, LO3–4, LO3–7
114
Chapter 3
Required:
1.
2.
Check your worksheet by changing the estimated total amount of the allocation base in the
Data area to 60,000 machine-hours, keeping all of the other data the same as in the original
example. If your worksheet is operating properly, the predetermined overhead rate should
now be $5.00 per machine-hour. If you do not get this answer, find the errors in your worksheet and correct them.
How much is the underapplied (overapplied) manufacturing overhead? Did it change?
Why or why not?
Determine the underapplied (overapplied) manufacturing overhead for a different company
with the following data:
Allocation base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Estimated manufacturing overhead cost . . . . . . . . . . . . . .
Estimated total amount of the allocation base . . . . . . . . . .
Actual manufacturing overhead cost . . . . . . . . . . . . . . . . .
Actual total amount of the allocation base . . . . . . . . . . . .
3.
4.
Machine-hours
$100,000
50,000 machine-hours
$90,000
40,000 machine-hours
What happens to the underapplied (overapplied) manufacturing overhead from part (2) if the
estimated total amount of the allocation base is changed to 40,000 machine-hours and everything else remains the same? Why is the amount of underapplied (overapplied) manufacturing
overhead different from part (2)?
Change the estimated total amount of the allocation base back to 50,000 machine-hours so
that the data look exactly like they did in part (2). Now change the actual manufacturing
overhead cost to $100,000. What is the underapplied (overapplied) manufacturing overhead
now? Why is the amount of underapplied (overapplied) manufacturing overhead different
from part (2)?
The Foundational 15
Available with McGraw-Hill’s Connect® Accounting.
LO3–1, LO3–2, LO3–3,
LO3–4, LO3–5, LO3–6,
LO3–7
Sweeten Company had no jobs in progress at the beginning of March and no beginning inventories. It started only two jobs during March—Job P and Job Q. Job P was completed and sold
by the end of the March and Job Q was incomplete at the end of the March. The company uses
a plantwide predetermined overhead rate based on direct labor-hours. The following additional
information is available for the company as a whole and for Jobs P and Q (all data and questions
relate to the month of March):
Estimated total fixed manufacturing overhead . . . . . . . . . . . . . . . . . . . . . .
Estimated variable manufacturing overhead per direct labor-hour . . . . . . .
Estimated total direct labor-hours to be worked . . . . . . . . . . . . . . . . . . . . .
Total actual manufacturing overhead costs incurred . . . . . . . . . . . . . . . . . .
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Actual direct labor-hours worked . . . . . . . . . . . . . . . . . . . .
1.
2.
3.
4.
5.
$10,000
$1.00
2,000
$12,500
Job P
Job Q
$13,000
$21,000
1,400
$8,000
$7,500
500
What is the company’s predetermined overhead rate?
How much manufacturing overhead was applied to Job P and Job Q?
What is the direct labor hourly wage rate?
If Job P includes 20 units, what is its unit product cost? What is the total amount of manufacturing cost assigned to Job Q as of the end of March (including applied overhead)?
Assume the ending raw materials inventory is $1,000 and the company does not use any indirect materials. Prepare the journal entries to record raw materials purchases and the issuance
of direct materials for use in production.
Job-Order Costing
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
115
Assume that the company does not use any indirect labor. Prepare the journal entry to record
the direct labor costs added to production.
Prepare the journal entry to apply manufacturing overhead costs to production.
Assume the ending raw materials inventory is $1,000 and the company does not use any
indirect materials. Prepare a schedule of cost of goods manufactured.
Prepare the journal entry to transfer costs from Work in Process to Finished Goods.
Prepare a completed Work in Process T-account including the beginning and ending balances and all debits and credits posted to the account.
Prepare a schedule of cost of goods sold. (Stop after computing the unadjusted cost of
goods sold.)
Prepare the journal entry to transfer costs from Finished Goods to Cost of Goods Sold.
What is the amount of underapplied or overapplied overhead?
Prepare the journal entry to close the amount of underapplied or overapplied overhead to
Cost of Goods Sold.
Assume that Job P includes 20 units that each sell for $3,000 and that the company’s selling
and administrative expenses in March were $14,000. Prepare an absorption costing income
statement for March.
Exercises
All applicable exercises are available with McGraw-Hill’s Connect® Accounting.
EXERCISE 3–1 Compute the Predetermined Overhead Rate [LO3–1]
Harris Fabrics computes its predetermined overhead rate annually on the basis of direct laborhours. At the beginning of the year, it estimated that 20,000 direct labor-hours would be required
for the period’s estimated level of production. The company also estimated $94,000 of fixed manufacturing overhead expenses for the coming period and variable manufacturing overhead of $2.00
per direct labor-hour. Harris’s actual manufacturing overhead for the year was $123,900 and its
actual total direct labor was 21,000 hours.
Required:
Compute the company’s predetermined overhead rate for the year.
EXERCISE 3–2 Apply Overhead [LO3–2]
Luthan Company uses a predetermined overhead rate of $23.40 per direct labor-hour. This predetermined rate was based on a cost formula that estimated $257,400 of total manufacturing overhead for an estimated activity level of 11,000 direct labor-hours.
The company incurred actual total manufacturing overhead costs of $249,000 and 10,800
total direct labor-hours during the period.
Required:
Determine the amount of manufacturing overhead that would have been applied to all jobs during
the period.
EXERCISE 3–3 Computing Job Costs [LO3–3]
Mickley Company’s predetermined overhead rate is $14.00 per direct labor-hour and its direct
labor wage rate is $12.00 per hour. The following information pertains to Job A-500:
Direct materials . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . .
$230
$108
Required:
1.
2.
What is the total manufacturing cost assigned to Job A-500?
If Job A-500 consists of 40 units, what is the average cost assigned to each unit included in
the job?
EXERCISE 3–4 Prepare Journal Entries [LO3–4]
Larned Corporation recorded the following transactions for the just completed month.
a. $80,000 in raw materials were purchased on account.
b. $71,000 in raw materials were requisitioned for use in production. Of this amount, $62,000
was for direct materials and the remainder was for indirect materials.
116
Chapter 3
c.
d.
Total labor wages of $112,000 were incurred. Of this amount, $101,000 was for direct labor
and the remainder was for indirect labor.
Additional manufacturing overhead costs of $175,000 were incurred.
Required:
Record the above transactions in journal entries.
EXERCISE 3–5 Prepare T-Accounts [LO3–5, LO3–7]
Jurvin Enterprises recorded the following transactions for the just completed month. The company
had no beginning inventories.
a. $94,000 in raw materials were purchased for cash.
b. $89,000 in raw materials were requisitioned for use in production. Of this amount, $78,000
was for direct materials and the remainder was for indirect materials.
c. Total labor wages of $132,000 were incurred and paid. Of this amount, $112,000 was for
direct labor and the remainder was for indirect labor.
d. Additional manufacturing overhead costs of $143,000 were incurred and paid.
e. Manufacturing overhead costs of $152,000 were applied to jobs using the company’s predetermined overhead rate.
f. All of the jobs in progress at the end of the month were completed and shipped to customers.
g. Any underapplied or overapplied overhead for the period was closed out to Cost of Goods
Sold.
Required:
1.
2.
Post the above transactions to T-accounts.
Determine the cost of goods sold for the period.
EXERCISE 3–6 Schedules of Cost of Goods Manufactured and Cost of Goods Sold [LO3–6]
Primare Corporation has provided the following data concerning last month’s manufacturing
operations.
Purchases of raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Indirect materials included in manufacturing overhead . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead applied to work in process . . . . . . . . . . . . . . . . . .
Underapplied overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories
Raw materials . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process . . . . . . . . . . . . . . . . . . . . . . .
Finished goods . . . . . . . . . . . . . . . . . . . . . . .
Beginning
Ending
$12,000
$56,000
$35,000
$18,000
$65,000
$42,000
$30,000
$5,000
$58,000
$87,000
$4,000
Required:
1.
2.
Prepare a schedule of cost of goods manufactured for the month.
Prepare a schedule of cost of goods sold for the month.
EXERCISE 3–7 Underapplied and Overapplied Overhead [LO3–7]
Osborn Manufacturing uses a predetermined overhead rate of $18.20 per direct labor-hour. This
predetermined rate was based on a cost formula that estimates $218,400 of total manufacturing
overhead for an estimated activity level of 12,000 direct labor-hours.
The company incurred actual total manufacturing overhead costs of $215,000 and 11,500 total
direct labor-hours during the period.
Required:
1.
2.
Determine the amount of underapplied or overapplied manufacturing overhead for the period.
Assuming that the entire amount of the underapplied or overapplied overhead is closed out to
Cost of Goods Sold, what would be the effect of the underapplied or overapplied overhead on
the company’s gross margin for the period?
EXERCISE 3–8 Applying Overhead; Computing Unit Product Cost [LO3–2, LO3–3]
A company assigns overhead cost to completed jobs on the basis of 125% of direct labor cost. The
job cost sheet for Job 313 shows that $10,000 in direct materials has been used on the job and that
$12,000 in direct labor cost has been incurred. A total of 1,000 units were produced in Job 313.
Job-Order Costing
Required:
What is the total manufacturing cost assigned to Job 313? What is the unit product cost for Job 313?
EXERCISE 3–9 Journal Entries and T-accounts [LO3–2, LO3–4, LO3–5]
The Polaris Company uses a job-order costing system. The following data relate to October, the
first month of the company’s fiscal year.
a. Raw materials purchased on account, $210,000.
b. Raw materials issued to production, $190,000 ($178,000 direct materials and $12,000 indirect
materials).
c. Direct labor cost incurred, $90,000; indirect labor cost incurred, $110,000.
d. Depreciation recorded on factory equipment, $40,000.
e. Other manufacturing overhead costs incurred during October, $70,000 (credit Accounts
Payable).
f. The company applies manufacturing overhead cost to production on the basis of $8 per
machine-hour. A total of 30,000 machine-hours were recorded for October.
g. Production orders costing $520,000 according to their job cost sheets were completed during
October and transferred to Finished Goods.
h. Production orders that had cost $480,000 to complete according to their job cost sheets were
shipped to customers during the month. These goods were sold on account at 25% above cost.
Required:
1.
2.
Prepare journal entries to record the information given above.
Prepare T-accounts for Manufacturing Overhead and Work in Process. Post the relevant information above to each account. Compute the ending balance in each account, assuming that
Work in Process has a beginning balance of $42,000.
EXERCISE 3–10 Applying Overhead to a Job [LO3–2]
Sigma Corporation applies overhead cost to jobs on the basis of direct labor cost. Job V, which
was started and completed during the current period, shows charges of $5,000 for direct materials,
$8,000 for direct labor, and $6,000 for overhead on its job cost sheet. Job W, which is still in process at year-end, shows charges of $2,500 for direct materials and $4,000 for direct labor.
Required:
Should any overhead cost be added to Job W at year-end? If so, how much? Explain.
EXERCISE 3–11 Schedules of Cost of Goods Manufactured and Cost of Goods Sold; Income
Statement [LO3–6]
The following data from the just completed year are taken from the accounting records of Mason
Company:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Raw material purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead applied to work in process . . . . . . . . .
Actual manufacturing overhead costs . . . . . . . . . . . . . . . . . . . .
Inventories
Raw materials . . . . . . . . . . . . . . . . . . . . . . . .
Work in process . . . . . . . . . . . . . . . . . . . . . .
Finished goods . . . . . . . . . . . . . . . . . . . . . . .
$524,000
$70,000
$118,000
$140,000
$63,000
$90,000
$80,000
Beginning of
Year
End of Year
$7,000
$10,000
$20,000
$15,000
$5,000
$35,000
Required:
1.
2.
3.
Prepare a schedule of cost of goods manufactured. Assume all raw materials used in production were direct materials.
Prepare a schedule of cost of goods sold.
Prepare an income statement.
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Chapter 3
EXERCISE 3–12 Applying Overhead; Cost of Goods Manufactured [LO3–2, LO3–6, LO3–7]
The following cost data relate to the manufacturing activities of Chang Company during the just
completed year:
Manufacturing overhead costs incurred:
Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property taxes, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Utilities, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Insurance, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 15,000
130,000
8,000
70,000
240,000
10,000
Total actual manufacturing overhead costs incurred . . . . . . . . . . . . . .
$473,000
Other costs incurred:
Purchases of raw materials (both direct and indirect) . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$400,000
$60,000
Inventories:
Raw materials, beginning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Raw materials, ending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process, beginning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process, ending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$20,000
$30,000
$40,000
$70,000
The company uses a predetermined overhead rate to apply overhead cost to jobs. The rate for the
year was $25 per machine-hour. A total of 19,400 machine-hours was recorded for the year.
Required:
1.
2.
Compute the amount of underapplied or overapplied overhead cost for the year.
Prepare a schedule of cost of goods manufactured for the year.
EXERCISE 3–13 Varying Predetermined Overhead Rates [LO3–1, LO3–2, LO3–3]
Kingsport Containers Company makes a single product that is subject to wide seasonal variations
in demand. The company uses a job-order costing system and computes predetermined overhead
rates on a quarterly basis using the number of units to be produced as the allocation base. Its estimated costs, by quarter, for the coming year are given below:
Quarter
First
Second
Third
Fourth
Direct materials . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . . . . .
$240,000
128,000
300,000
$120,000
64,000
220,000
$ 60,000
32,000
180,000
$180,000
96,000
?
Total manufacturing costs (a) . . . . . . . . . . . .
$668,000
$404,000
$272,000
$
Number of units to be produced (b) . . . . . . .
Estimated unit product cost (a) 4 (b) . . . . . .
80,000
$8.35
40,000
$10.10
20,000
$13.60
?
60,000
?
Management finds the variation in quarterly unit product costs to be confusing and difficult to
work with. It has been suggested that the problem lies with manufacturing overhead because it is
the largest element of total manufacturing cost. Accordingly, you have been asked to find a more
appropriate way of assigning manufacturing overhead cost to units of product.
Required:
1.
2.
3.
Using the high-low method, estimate the fixed manufacturing overhead cost per quarter and
the variable manufacturing overhead cost per unit. Create a cost formula to estimate the total
manufacturing overhead cost for the fourth quarter. Compute the total manufacturing cost and
unit product cost for the fourth quarter.
What is causing the estimated unit product cost to fluctuate from one quarter to the next?
How would you recommend stabilizing the company’s unit product cost? Support your answer
with computations that adapt the cost formula you created in requirement 1.
Job-Order Costing
EXERCISE 3–14 Computing Predetermined Overhead Rates and Job Costs [LO3–1, LO3–2, LO3–3,
LO3–7]
Moody Corporation uses a job-order costing system with a plantwide overhead rate based on
machine-hours. At the beginning of the year, the company made the following estimates:
Machine-hours required to support estimated production . . . . . .
Fixed manufacturing overhead cost . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead cost per machine-hour . . . . . . .
100,000
$650,000
$3.00
Required:
1.
2.
Compute the predetermined overhead rate.
During the year, Job 400 was started and completed. The following information was available
with respect to this job:
Direct materials requisitioned . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Machine-hours used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.
$450
$210
40
Compute the total manufacturing cost assigned to Job 400.
During the year, the company worked a total of 146,000 machine-hours on all jobs and
incurred actual manufacturing overhead costs of $1,350,000. What is the amount of underapplied or overapplied overhead for the year? If this amount were closed out entirely to Cost of
Goods Sold would the journal entry increase or decrease net operating income?
EXERCISE 3–15 Departmental Overhead Rates [LO3–1, LO3–2, LO3–3]
White Company has two departments, Cutting and Finishing. The company uses a job-order
costing system and computes a predetermined overhead rate in each department. The Cutting
Department bases its rate on machine-hours, and the Finishing Department bases its rate on direct
labor-hours. At the beginning of the year, the company made the following estimates:
Department
Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total fixed manufacturing overhead cost . . . . . . . . . . . . . . . .
Variable manufacturing overhead per machine-hour . . . . . . .
Variable manufacturing overhead per direct labor-hour . . . . .
Cutting
Finishing
6,000
48,000
$264,000
$2.00
—
30,000
5,000
$366,000
—
$4.00
Required:
1.
2.
Compute the predetermined overhead rate to be used in each department.
Assume that the overhead rates that you computed in (1) above are in effect. The job cost
sheet for Job 203, which was started and completed during the year, showed the following:
Department
Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Materials requisitioned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.
Cutting
Finishing
6
80
$500
$70
20
4
$310
$150
Compute the total manufacturing cost assigned to Job 203.
Would you expect substantially different amounts of overhead cost to be assigned to some
jobs if the company used a plantwide overhead rate based on direct labor-hours, rather than
using departmental rates? Explain. No computations are necessary.
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Chapter 3
EXERCISE 3–16 Applying Overhead; Journal Entries; Disposition of Underapplied or Overapplied
Overhead [LO3–4, LO3–5, LO3–7]
The following information is taken from the accounts of Latta Company. The entries in the
T-accounts are summaries of the transactions that affected those accounts during the year.
Manufacturing Overhead
(a)
Bal.
460,000
(b)
390,000
Work in Process
Bal.
15,000
260,000
85,000
390,000
70,000
(b)
Bal.
Finished Goods
Bal.
(c)
50,000
710,000
Bal.
120,000
(d)
(c)
710,000
40,000
Cost of Goods Sold
640,000
(d)
640,000
The overhead that had been applied to production during the year is distributed among the
ending balances in the accounts as follows:
Work in Process, ending . . . . . . . . . . . . .
Finished Goods, ending . . . . . . . . . . . . . .
Cost of Goods Sold . . . . . . . . . . . . . . . . .
$ 19,500
58,500
312,000
Overhead applied . . . . . . . . . . . . . . . . . .
$390,000
For example, of the $40,000 ending balance in Work in Process, $19,500 was overhead that had
been applied during the year.
Required:
1.
2.
3.
Identify reasons for entries (a) through (d).
Assume that the company closes any balance in the Manufacturing Overhead account directly
to Cost of Goods Sold. Prepare the necessary journal entry.
Assume instead that the company allocates any balance in the Manufacturing Overhead
account to the other accounts in proportion to the overhead applied in their ending balances.
Prepare the necessary journal entry, with supporting computations.
EXERCISE 3–17 Plantwide and Departmental Overhead Rates; Job Costs [LO3–1, LO3–2, LO3–3]
Delph Company uses a job-order costing system and has two manufacturing departments—
Molding and Fabrication. The company provided the following estimates at the beginning of
the year:
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead costs . . . . . . . . . . . . . . .
Variable manufacturing overhead per machine-hour . . .
Molding
Fabrication
Total
20,000
$700,000
$3.00
30,000
$210,000
$3.00
50,000
$910,000
During the year, the company had no beginning or ending inventories and it started, completed,
and sold only two jobs—Job D-70 and Job C-200. It provided the following information related to
those two jobs:
Job D-70
Molding
Fabrication
Total
Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$375,000
$200,000
14,000
$325,000
$160,000
6,000
$700,000
$360,000
20,000
Job-Order Costing
Job C-200
Molding
Fabrication
Total
Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$300,000
$175,000
6,000
$250,000
$225,000
24,000
$550,000
$400,000
30,000
Delph had no overapplied or underapplied manufacturing overhead during the year.
Required:
1.
2.
3.
Assume Delph uses a plantwide overhead rate based on machine-hours.
a. Compute the predetermined plantwide overhead rate.
b. Compute the total manufacturing costs assigned to Job D-70 and Job C-200.
c. If Delph establishes bid prices that are 150% of total manufacturing costs, what bid price
would it have established for Job D-70 and Job C-200?
d. What is Delph’s cost of goods sold for the year?
Assume Delph uses departmental overhead rates based on machine-hours.
a. Compute the predetermined departmental overhead rates.
b. Compute the total manufacturing costs assigned to Job D-70 and Job C-200.
c. If Delph establishes bid prices that are 150% of total manufacturing costs, what bid price
would it have established for Job D-70 and Job C-200?
d. What is Delph’s cost of goods sold for the year?
What managerial insights are revealed by the computations that you performed in this problem? (Hint: Do the cost of goods sold amounts that you computed in requirements 1 and 2
differ from one another? Do the bid prices that you computed in requirements 1 and 2 differ
from one another? Why?)
EXERCISE 3–18 Applying Overhead; T-accounts; Journal Entries [LO3–1, LO3–2, LO3–4, LO3–5, LO3–7]
Harwood Company uses a job-order costing system. Overhead costs are applied to jobs on the
basis of machine-hours. At the beginning of the year, management estimated that 80,000 machinehours would be required for the period’s estimated level of production. The company also estimated $128,000 of fixed manufacturing overhead expenses for the coming period and variable
manufacturing overhead of $0.80 per machine-hour.
Required:
1.
2.
Compute the company’s predetermined overhead rate.
Assume that during the year the company works only 75,000 machine-hours and incurs the
following costs in the Manufacturing Overhead and Work in Process accounts:
Manufacturing
Overhead
(Maintenance)
(Indirect materials)
(Indirect labor)
(Utilities)
(Insurance)
(Depreciation)
3.
4.
21,000
8,000
60,000
32,000
7,000
56,000
?
Work in
Process
(Direct materials)
(Direct labor)
(Overhead)
710,000
90,000
?
Copy the data in the T-accounts above onto your answer sheet. Compute the amount of overhead
cost that would be applied to Work in Process for the year and make the entry in your T-accounts.
Compute the amount of underapplied or overapplied overhead for the year and show the balance in your Manufacturing Overhead T-account. Prepare a journal entry to close out the balance in this account to Cost of Goods Sold.
Explain why the manufacturing overhead was underapplied or overapplied for the year.
EXERCISE 3–19 Applying Overhead in a Service Company [LO3–1, LO3–2, LO3–3]
Leeds Architectural Consultants began operations on January 2. The following activity was
recorded in the company’s Work in Process account for the first month of operations:
Work in Process
Costs of subcontracted work
Direct staff costs
Studio overhead
230,000
75,000
120,000
To completed projects
390,000
121
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Chapter 3
Leeds Architectural Consultants is a service firm, so the names of the accounts it uses are
different from the names used in manufacturing companies. Costs of Subcontracted Work is comparable to Direct Materials; Direct Staff Costs is the same as Direct Labor; Studio Overhead is the
same as Manufacturing Overhead; and Completed Projects is the same as Finished Goods. Apart
from the difference in terms, the accounting methods used by the company are identical to the
methods used by manufacturing companies.
Leeds Architectural Consultants uses a job-order costing system and applies studio overhead to Work in Process on the basis of direct staff costs. At the end of January, only one job was
still in process. This job (Lexington Gardens Project) had been charged with $6,500 in direct
staff costs.
Required:
1.
2.
Compute the predetermined overhead rate that was in use during January.
Complete the following job cost sheet for the partially completed Lexington Gardens Project.
Job Cost Sheet—Lexington Gardens Project
As of January 31
Costs of subcontracted work . . . . . . . . . . . . . . .
Direct staff costs . . . . . . . . . . . . . . . . . . . . . . . .
Studio overhead . . . . . . . . . . . . . . . . . . . . . . . .
$ ?
?
?
Total cost to January 31 . . . . . . . . . . . . . . . . . .
$ ?
EXERCISE 3–20 Applying Overhead; Journal Entries; T-accounts [LO3–1, LO3–2, LO3–3, LO3–4, LO3–5]
Dillon Products manufactures various machined parts to customer specifications. The company
uses a job-order costing system and applies overhead cost to jobs on the basis of machine-hours.
At the beginning of the year, the company used a cost formula to estimate that it would incur
$4,800,000 in manufacturing overhead costs at an activity level of 240,000 machine-hours.
The company spent the entire month of January working on a large order for 16,000 custommade machined parts. The company had no work in process at the beginning of January. Cost data
relating to January follow:
a. Raw materials purchased on account, $325,000.
b. Raw materials requisitioned for production, $290,000 (80% direct materials and 20% indirect
materials).
c. Labor cost incurred in the factory, $180,000 (one-third direct labor and two-thirds indirect
labor).
d. Depreciation recorded on factory equipment, $75,000.
e. Other manufacturing overhead costs incurred, $62,000 (credit Accounts Payable).
f. Manufacturing overhead cost was applied to production on the basis of 15,000 machine-hours
actually worked during the month.
g. The completed job was moved into the finished goods warehouse on January 31 to await
delivery to the customer. (In computing the dollar amount for this entry, remember that the
cost of a completed job consists of direct materials, direct labor, and applied overhead.)
Required:
1.
2.
3.
4.
Prepare journal entries to record items (a) through (f) above [ignore item (g) for the moment].
Prepare T-accounts for Manufacturing Overhead and Work in Process. Post the relevant items
from your journal entries to these T-accounts.
Prepare a journal entry for item (g) above.
Compute the unit product cost that will appear on the job cost sheet.
Problems
All applicable problems are available with McGraw-Hill’s Connect® Accounting.
PROBLEM 3–21 T-Account Analysis of Cost Flows [LO3–1, LO3–5, LO3–6, LO3–7]
Selected T-accounts of Moore Company are given below for the just completed year:
Job-Order Costing
Raw Materials
Bal. 1/1
Debits
15,000
120,000
Bal. 12/31
Credits
Manufacturing Overhead
?
Debits
230,000
Bal. 1/1
Direct materials
Direct labor
Overhead
20,000
90,000
150,000
240,000
Credits
470,000
Debits
185,000
40,000
?
Bal. 12/31
60,000
Bal. 12/31
Credits
Cost of Goods Sold
?
Debits
?
Required:
7.
8.
Bal. 1/1
Credits
?
Bal. 1/1
Debits
6.
?
Factory Wages Payable
Finished Goods
1.
2.
3.
4.
5.
Credits
25,000
Work in Process
Bal. 12/31
123
What was the cost of raw materials put into production during the year?
How much of the materials in (1) above consisted of indirect materials?
How much of the factory labor cost for the year consisted of indirect labor?
What was the cost of goods manufactured for the year?
What was the cost of goods sold for the year (before considering underapplied or overapplied
overhead)?
If overhead is applied to production on the basis of direct labor cost, what rate was in effect
during the year?
Was manufacturing overhead underapplied or overapplied? By how much?
Compute the ending balance in the Work in Process inventory account. Assume that this balance consists entirely of goods started during the year. If $8,000 of this balance is direct labor
cost, how much of it is direct materials cost? Manufacturing overhead cost?
PROBLEM 3–22 Predetermined Overhead Rate; Disposition of Underapplied or Overapplied Overhead [LO3–1, LO3–7]
Luzadis Company makes furniture using the latest automated technology. The company uses a
job-order costing system and applies manufacturing overhead cost to products on the basis of
machine-hours. The following estimates were used in preparing the predetermined overhead rate
at the beginning of the year:
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead cost . . . . . . . . . . . . . . . . .
Variable manufacturing overhead per computer-hour . . .
75,000
$795,000
$1.40
During the year, a glut of furniture on the market resulted in cutting back production and a
buildup of furniture in the company’s warehouse. The company’s cost records revealed the following actual cost and operating data for the year:
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories at year-end:
Raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process (includes overhead applied of 36,000) . . . . . . . . . . . .
Finished goods (includes overhead applied of 180,000) . . . . . . . . . . . .
Cost of goods sold (includes overhead applied of 504,000) . . . . . . . . . . .
60,000
$850,000
$30,000
$100,000
$500,000
$1,400,000
9,000
180,000
4,000
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Chapter 3
Required:
1.
2.
3.
4.
5.
Compute the company’s predetermined overhead rate.
Compute the underapplied or overapplied overhead.
Assume that the company closes any underapplied or overapplied overhead directly to Cost of
Goods Sold. Prepare the appropriate journal entry.
Assume that the company allocates any underapplied or overapplied overhead to Work in
Process, Finished Goods, and Cost of Goods Sold on the basis of the amount of overhead
applied that remains in each account at the end of the year. Prepare the journal entry to show
the allocation for the year.
How much higher or lower will net operating income be if the underapplied or overapplied
overhead is allocated rather than closed directly to Cost of Goods Sold?
PROBLEM 3–23 Schedules of Cost of Goods Manufactured and Cost of Goods Sold; Income
Statement [LO3–6]
Superior Company provided the following account balances for the year ended December 31 (all
raw materials are used in production as direct materials):
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Purchases of raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead applied to work in process . . . . . . . . . .
Total actual manufacturing overhead costs . . . . . . . . . . . . . . . .
$140,000
$290,000
?
$100,000
$285,000
$270,000
Inventory balances at the beginning and end of the year were as follows:
Beginning of
Year
Raw materials . . . . . . . . . . . . . . . . . . . . . . .
Work in process . . . . . . . . . . . . . . . . . . . . . .
Finished goods . . . . . . . . . . . . . . . . . . . . . .
$40,000
?
$50,000
End of Year
$10,000
$35,000
?
The total manufacturing costs for the year were $683,000; the cost of goods available for sale
totaled $740,000; the unadjusted cost of goods sold totaled $660,000; and the net operating income
was $30,000. The company’s overapplied or underapplied overhead is closed entirely to Cost of
Goods Sold.
Required:
Prepare schedules of cost of goods manufactured and cost of goods sold and an income statement.
(Hint: Prepare the income statement and schedule of cost of goods sold first followed by the schedule of cost of goods manufactured.)
PROBLEM 3–24 Multiple Departments; Applying Overhead [LO3–1, LO3–2, LO3–3, LO3–7]
High Desert Potteryworks makes a variety of pottery products that it sells to retailers such as Home
Depot. The company uses a job-order costing system in which predetermined overhead rates are
used to apply manufacturing overhead cost to jobs. The predetermined overhead rate in the Molding
Department is based on machine-hours, and the rate in the Painting Department is based on direct
labor-hours. At the beginning of the year, the company’s management made the following estimates:
Department
Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead cost . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead per machine-hour . . . . . .
Variable manufacturing overhead per direct labor-hour . . . . .
Molding
Painting
12,000
70,000
$510,000
$130,000
$497,000
$1.50
–
60,000
8,000
$650,000
$420,000
$615,000
–
$2.00
Job-Order Costing
Job 205 was started on August 1 and completed on August 10. The company’s cost records
show the following information concerning the job:
Department
Molding
Painting
30
110
$470
$325
84
20
$332
$588
Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . .
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . .
Materials placed into production . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . .
Required:
1.
2.
3.
4.
Compute the predetermined overhead rate used during the year in the Molding Department.
Compute the rate used in the Painting Department.
Compute the total overhead cost applied to Job 205.
What would be the total cost recorded for Job 205? If the job contained 50 units, what would
be the unit product cost?
At the end of the year, the records of High Desert Potteryworks revealed the following actual
cost and operating data for all jobs worked on during the year:
Department
Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . .
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead cost . . . . . . . . . . . . . . . .
Molding
Painting
10,000
65,000
$430,000
$108,000
$570,000
62,000
9,000
$680,000
$436,000
$750,000
What was the amount of underapplied or overapplied overhead in each department at the end of
the year?
PROBLEM 3–25 Schedule of Cost of Goods Manufactured; Overhead Analysis [LO3–1, LO3–2, LO3–3,
LO3–6, LO3–7]
Gitano Products operates a job-order costing system and applies overhead cost to jobs on the basis
of direct materials used in production (not on the basis of raw materials purchased). Its predetermined overhead rate was based on a cost formula that estimated $800,000 of manufacturing overhead for an estimated allocation base of $500,000 direct material dollars to be used in production.
The company has provided the following data for the just completed year:
Purchase of raw materials . . . . . . . . . . . . . . . . . . .
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead costs:
Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property taxes . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation of equipment . . . . . . . . . . . . . . . .
Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . .
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Rent, building . . . . . . . . . . . . . . . . . . . . . . . . . . .
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . .
$510,000
$ 90,000
$170,000
$ 48,000
$260,000
$ 95,000
$ 7,000
$180,000
Beginning
Ending
$ 20,000
$150,000
$260,000
$ 80,000
$ 70,000
$400,000
125
126
Chapter 3
Required:
1.
2.
3.
4.
5.
a. Compute the predetermined overhead rate for the year.
b. Compute the amount of underapplied or overapplied overhead for the year.
Prepare a schedule of cost of goods manufactured for the year. Assume all raw materials are
used in production as direct materials.
Compute the unadjusted cost of goods sold for the year. (Do not include any underapplied or
overapplied overhead in your cost of goods sold figure.) What options are available for disposing of underapplied or overapplied overhead?
Job 215 was started and completed during the year. What price would have been charged to
the customer if the job required $8,500 in direct materials and $2,700 in direct labor cost and
the company priced its jobs at 25% above the job’s cost according to the accounting system?
Direct materials made up $24,000 of the $70,000 ending Work in Process inventory balance.
Supply the information missing below:
Direct materials . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . . .
$24,000
?
?
Work in process inventory . . . . . . . . . . . .
$70,000
PROBLEM 3–26 Journal Entries; T-Accounts; Financial Statements [LO3–1, LO3–2, LO3–3, LO3–4,
LO3–5, LO3–6, LO3–7]
Froya Fabrikker A/S of Bergen, Norway, is a small company that manufactures specialty heavy
equipment for use in North Sea oil fields. The company uses a job-order costing system and
applies manufacturing overhead cost to jobs on the basis of direct labor-hours. Its predetermined
overhead rate was based on a cost formula that estimated $360,000 of manufacturing overhead for
an estimated allocation base of 900 direct labor-hours. The following transactions took place during the year (all purchases and services were acquired on account):
a. Raw materials were purchased for use in production, $200,000.
b. Raw materials were requisitioned for use in production (all direct materials), $185,000.
c. Utility bills were incurred, $70,000 (90% related to factory operations, and the remainder
related to selling and administrative activities).
d. Salary and wage costs were incurred:
Direct labor (975 hours) . . . . . . . . . . . . . .
Indirect labor . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative salaries . . . . . .
$230,000
$90,000
$110,000
e.
f.
g.
Maintenance costs were incurred in the factory, $54,000.
Advertising costs were incurred, $136,000.
Depreciation was recorded for the year, $95,000 (80% related to factory equipment, and the
remainder related to selling and administrative equipment).
h. Rental cost incurred on buildings, $120,000 (85% related to factory operations, and the
remainder related to selling and administrative facilities).
i. Manufacturing overhead cost was applied to jobs, $ ? .
j. Cost of goods manufactured for the year, $770,000.
k. Sales for the year (all on account) totaled $1,200,000. These goods cost $800,000 according
to their job cost sheets.
The balances in the inventory accounts at the beginning of the year were:
Raw Materials . . . . . . . . . . . . . . . . . . . . .
Work in Process . . . . . . . . . . . . . . . . . . .
Finished Goods . . . . . . . . . . . . . . . . . . . .
$30,000
$21,000
$60,000
Required:
1.
2.
Prepare journal entries to record the preceding data.
Post your entries to T-accounts. (Don’t forget to enter the beginning inventory balances
above.) Determine the ending balances in the inventory accounts and in the Manufacturing
Overhead account.
Job-Order Costing
3.
4.
5.
6.
Prepare a schedule of cost of goods manufactured.
Prepare a journal entry to close any balance in the Manufacturing Overhead account to Cost
of Goods Sold. Prepare a schedule of cost of goods sold.
Prepare an income statement for the year.
Job 412 was one of the many jobs started and completed during the year. The job required
$8,000 in direct materials and 39 hours of direct labor time at a total direct labor cost of $9,200.
The job contained only four units. If the company bills at a price 60% above the unit product
cost on the job cost sheet, what price per unit would have been charged to the customer?
PROBLEM 3–27 Comprehensive Problem [LO3–1, LO3–2, LO3–4, LO3–5, LO3–7]
Gold Nest Company of Guandong, China, is a family-owned enterprise that makes birdcages for
the South China market. The company sells its birdcages through an extensive network of street
vendors who receive commissions on their sales. All of the company’s transactions with customers, employees, and suppliers are conducted in cash; there is no credit.
The company uses a job-order costing system in which overhead is applied to jobs on the
basis of direct labor cost. Its predetermined overhead rate is based on a cost formula that estimated
$330,000 of manufacturing overhead for an estimated activity level of $200,000 direct labor dollars. At the beginning of the year, the inventory balances were as follows:
Raw materials . . . . . . . . . . . . . . . . . . . . .
Work in process . . . . . . . . . . . . . . . . . . . .
Finished goods . . . . . . . . . . . . . . . . . . . .
a.
b.
c.
During the year, the following transactions were completed:
Raw materials purchased for cash, $275,000.
Raw materials requisitioned for use in production, $280,000 (materials costing $220,000 were
charged directly to jobs; the remaining materials were indirect).
Costs for employee services were incurred as follows:
Direct labor . . . . . . . . . . . . . . . . . . . . . . .
Indirect labor . . . . . . . . . . . . . . . . . . . . . .
Sales commissions . . . . . . . . . . . . . . . . . .
Administrative salaries . . . . . . . . . . . . . . .
d.
e.
f.
g.
h.
i.
j.
$25,000
$10,000
$40,000
$180,000
$72,000
$63,000
$90,000
Rent for the year was $18,000 ($13,000 of this amount related to factory operations, and the
remainder related to selling and administrative activities).
Utility costs incurred in the factory, $57,000.
Advertising costs incurred, $140,000.
Depreciation recorded on equipment, $100,000. ($88,000 of this amount was on equipment
used in factory operations; the remaining $12,000 was on equipment used in selling and
administrative activities.)
Manufacturing overhead cost was applied to jobs, $ ? .
Goods that had cost $675,000 to manufacture according to their job cost sheets were
completed.
Sales for the year totaled $1,250,000. The total cost to manufacture these goods according to
their job cost sheets was $700,000.
Required:
1.
2.
3.
4.
Prepare journal entries to record the transactions for the year.
Prepare T-accounts for inventories, Manufacturing Overhead, and Cost of Goods Sold. Post
relevant data from your journal entries to these T-accounts (don’t forget to enter the beginning
balances in your inventory accounts). Compute an ending balance in each account.
Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry
to close any balance in the Manufacturing Overhead account to Cost of Goods Sold.
Prepare an income statement for the year. (Do not prepare a schedule of cost of goods manufactured; all of the information needed for the income statement is available in the journal
entries and T-accounts you have prepared.)
127
128
Chapter 3
PROBLEM 3–28 Cost Flows; T-Accounts; Income Statement [LO3–1, LO3–2, LO3–5, LO3–6, LO3–7]
Supreme Videos, Inc., produces short musical videos for sale to retail outlets. The company’s balance sheet accounts as of January 1, the beginning of its fiscal year, are given below.
Supreme Videos, Inc.
Balance Sheet
January 1
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories:
Raw materials (film, costumes) . . . . . . . . . . . . . . . .
Videos in process . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finished videos awaiting sale . . . . . . . . . . . . . . . . .
$ 63,000
102,000
$ 30,000
45,000
81,000
156,000
Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Studio and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less accumulated depreciation . . . . . . . . . . . . . . . . . . .
330,000
730,000
210,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
520,000
$850,000
Liabilities and Stockholders’ Equity
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$420,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
270,000
Total liabilities and stockholders’ equity . . . . . . . . . . . . .
$160,000
690,000
$850,000
Because the videos differ in length and in complexity of production, the company uses a joborder costing system to determine the cost of each video produced. Studio (manufacturing) overhead is charged to videos on the basis of camera-hours of activity. The company’s predetermined
overhead rate for the year is based on a cost formula that estimated $280,000 in manufacturing
overhead for an estimated allocation base of 7,000 camera-hours. The following transactions were
recorded for the year:
a. Film, costumes, and similar raw materials purchased on account, $185,000.
b. Film, costumes, and other raw materials issued to production, $200,000 (85% of this material
was considered direct to the videos in production, and the other 15% was considered indirect).
c. Utility costs incurred in the production studio, $72,000.
d. Depreciation recorded on the studio, cameras, and other equipment, $84,000. Three-fourths
of this depreciation related to actual production of the videos, and the remainder related to
equipment used in marketing and administration.
e. Advertising expense incurred, $130,000.
f. Costs for salaries and wages were incurred as follows:
Direct labor (actors and directors) . . . . . . . . . . .
Indirect labor (carpenters to build sets,
costume designers, and so forth) . . . . . . . . . .
Administrative salaries . . . . . . . . . . . . . . . . . . . .
g.
h.
i.
j.
k.
$82,000
$110,000
$95,000
Prepaid insurance expired during the year, $7,000 (80% related to production of videos, and
20% related to marketing and administrative activities).
Miscellaneous marketing and administrative expenses incurred, $8,600.
Studio (manufacturing) overhead was applied to videos in production. The company recorded
7,250 camera-hours of activity during the year.
Videos that cost $550,000 to produce according to their job cost sheets were transferred to the
finished videos warehouse to await sale and shipment.
Sales for the year totaled $925,000 and were all on account. The total cost to produce these
videos according to their job cost sheets was $600,000.
Job-Order Costing
129
l. Collections from customers during the year totaled $850,000.
m. Payments to suppliers on account during the year, $500,000; payments to employees for salaries and wages, $285,000.
Required:
1.
2.
3.
4.
Prepare a T-account for each account on the company’s balance sheet and enter the beginning
balances.
Record the transactions directly into the T-accounts. Prepare new T-accounts as needed. Key
your entries to the letters (a) through (m) above. Compute the ending balance in each account.
Is the Studio (manufacturing) Overhead account underapplied or overapplied for the year?
Make an entry in the T-accounts to close any balance in the Studio Overhead account to Cost
of Goods Sold.
Prepare an income statement for the year. (Do not prepare a schedule of cost of goods manufactured; all of the information needed for the income statement is available in the T-accounts.)
Cases
All applicable cases are available with McGraw-Hill’s Connect® Accounting.
CASE 3–29 Ethics and the Manager [LO3–1, LO3–2, LO3–7]
Terri Ronsin had recently been transferred to the Home Security Systems Division of National
Home Products. Shortly after taking over her new position as divisional controller, she was asked
to develop the division’s predetermined overhead rate for the upcoming year. The accuracy of the
rate is important because it is used throughout the year and any overapplied or underapplied overhead is closed out to Cost of Goods Sold at the end of the year. National Home Products uses direct
labor-hours in all of its divisions as the allocation base for manufacturing overhead.
To compute the predetermined overhead rate, Terri divided her estimate of the total manufacturing overhead for the coming year by the production manager’s estimate of the total direct
labor-hours for the coming year. She took her computations to the division’s general manager for
approval but was quite surprised when he suggested a modification in the base. Her conversation
with the general manager of the Home Security Systems Division, Harry Irving, went like this:
Ronsin: Here are my calculations for next year’s predetermined overhead rate. If you approve, we can
enter the rate into the computer on January 1 and be up and running in the job-order costing system
right away this year.
Irving: Thanks for coming up with the calculations so quickly, and they look just fine. There is, however, one slight modification I would like to see. Your estimate of the total direct labor-hours for the
year is 440,000 hours. How about cutting that to about 420,000 hours?
Ronsin: I don’t know if I can do that. The production manager says she will need about 440,000 direct
labor-hours to meet the sales projections for the year. Besides, there are going to be over 430,000
direct labor-hours during the current year and sales are projected to be higher next year.
Irving: Teri, I know all of that. I would still like to reduce the direct labor-hours in the base to something like 420,000 hours. You probably don’t know that I had an agreement with your predecessor
as divisional controller to shave 5% or so off the estimated direct labor-hours every year. That way,
we kept a reserve that usually resulted in a big boost to net operating income at the end of the fiscal year in December. We called it our Christmas bonus. Corporate headquarters always seemed
as pleased as punch that we could pull off such a miracle at the end of the year. This system has
worked well for many years, and I don’t want to change it now.
Required:
1.
2.
Explain how shaving 5% off the estimated direct labor-hours in the base for the predetermined
overhead rate usually results in a big boost in net operating income at the end of the fiscal
year.
Should Terri Ronsin go along with the general manager’s request to reduce the direct laborhours in the predetermined overhead rate computation to 420,000 direct labor-hours?
CASE 3–30 Plantwide versus Departmental Overhead Rates; Underapplied or Overapplied Overhead
[LO3–1, LO3–2, LO3–3, LO3–7]
“Blast it!” said David Wilson, president of Teledex Company. “We’ve just lost the bid on the Koopers job by $2,000. It seems we’re either too high to get the job or too low to make any money on
half the jobs we bid.”
130
Chapter 3
Teledex Company manufactures products to customers’ specifications and operates a joborder costing system. Manufacturing overhead cost is applied to jobs on the basis of direct labor
cost. The following estimates were made at the beginning of the year:
Department
Direct labor . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . .
Fabricating
Machining
Assembly
Total Plant
$200,000
$350,000
$100,000
$400,000
$300,000
$90,000
$600,000
$840,000
Jobs require varying amounts of work in the three departments. The Koopers job, for example,
would have required manufacturing costs in the three departments as follows:
Department
Direct materials . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . .
Fabricating
Machining
Assembly
Total Plant
$3,000
$2,800
?
$200
$500
?
$1,400
$6,200
?
$4,600
$9,500
?
The company uses a plantwide overhead rate to apply manufacturing overhead cost to jobs.
Required:
1.
2.
3.
4.
5.
Assuming use of a plantwide overhead rate:
a. Compute the rate for the current year.
b. Determine the amount of manufacturing overhead cost that would have been applied to
the Koopers job.
Suppose that instead of using a plantwide overhead rate, the company had used a separate
predetermined overhead rate in each department. Under these conditions:
a. Compute the rate for each department for the current year.
b. Determine the amount of manufacturing overhead cost that would have been applied to
the Koopers job.
Explain the difference between the manufacturing overhead that would have been applied to
the Koopers job using the plantwide rate in question 1 (b) and using the departmental rates in
question 2 (b).
Assume that it is customary in the industry to bid jobs at 150% of total manufacturing cost
(direct materials, direct labor, and applied overhead). What was the company’s bid price on
the Koopers job? What would the bid price have been if departmental overhead rates had been
used to apply overhead cost?
At the end of the year, the company assembled the following actual cost data relating to all
jobs worked on during the year.
Department
Direct materials . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . .
Fabricating
Machining
Assembly
Total Plant
$190,000
$210,000
$360,000
$16,000
$108,000
$420,000
$114,000
$262,000
$84,000
$320,000
$580,000
$864,000
Compute the underapplied or overapplied overhead for the year (a) assuming that a plantwide
overhead rate is used, and (b) assuming that departmental overhead rates are used.
Appendix 3A: Activity-Based Absorption Costing
LO3–8
Use activity-based absorption
costing to compute unit
product costs.
Chapter 3 described how manufacturing companies use traditional absorption costing systems to calculate unit product costs for the purpose of valuing inventories and determining
cost of goods sold for external financial reports. In this appendix, we contrast traditional
absorption costing with an alternative approach called activity-based absorption costing.
Activity-based absorption costing assigns all manufacturing overhead costs to products based on the activities performed to make those products. An activity is an event that
Job-Order Costing
131
causes the consumption of manufacturing overhead resources. Rather than relying on plantwide or departmental cost pools, the activity-based approach accumulates each activity’s
overhead costs in activity cost pools. An activity cost pool is a “bucket” in which costs are
accumulated that relate to a single activity. Each activity cost pool has one activity measure.
An activity measure is an allocation base that is used as the denominator for an activity
cost pool. The costs accumulated in the numerator of an activity cost pool divided by the
quantity of the activity measure in its denominator equals what is called an activity rate. An
activity rate is used to assign costs from an activity cost pool to products.
Activity-based absorption costing differs from traditional absorption costing in two
ways. First, the activity-based approach uses more cost pools than a traditional approach.
Second, the activity-based approach includes some activities and activity measures that
do not relate to the volume of units produced, whereas the traditional approach relies
exclusively on allocation bases that are driven by the volume of production. For example,
the activity-based approach may include batch-level activities. A batch-level activity is
performed each time a batch is handled or processed, regardless of how many units are
in the batch. Batch-level activities include tasks such as placing purchase orders, setting up equipment, and transporting batches of component parts. Costs at the batch level
depend on the number of batches processed rather than the number of units produced.
The activity-based approach may also include product-level activities. A product-level
activity relates to specific products and typically must be carried out regardless of how
many batches are run or units of product are produced and sold. Product-level activities
include tasks such as designing a product and making engineering design changes to a
product. Costs at the product-level depend on the number of products supported rather
than the number of batches run or the number of units of product produced and sold.
To illustrate the differences between traditional and activity-based absorption costing, we’ll use an example focused on Maxtar Industries, a manufacturer of high-quality
smoker/barbecue units. The company has two product lines—Premium and Standard. The
company has traditionally applied manufacturing overhead costs to these products using a
plantwide predetermined overhead rate based on direct labor-hours. Exhibit 3A–1 details
how the unit product costs of the two product lines are computed using the company’s
Basic Data
Total estimated manufacturing overhead cost . . . . . .
Total estimated direct labor-hours . . . . . . . . . . . . . . .
Premium
Direct materials per unit . . . . . .
Direct labor per unit . . . . . . . . . .
Direct labor-hours per unit . . . .
Units produced . . . . . . . . . . . . .
$40.00
$24.00
2.0 DLHs
50,000 units
$1,520,000
400,000 DLHs
Standard
$30.00
$18.00
1.5 DLHs
200,000 units
Computation of the Predetermined Overhead Rate
Total estimated manufacturing overhead
Total estimated amount of the allocation base
$1,520,000
5 $3.80 per DLH
5
400,000 DLHs
Predetermined overhead rate 5
Traditional Unit Product Costs
Premium
Standard
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead (2.0 DLHs 3 $3.80
per DLH; 1.5 DLHs 3 $3.80 per DLH) . . . . . . . .
$40.00
24.00
$30.00
18.00
7.60
5.70
Unit product cost . . . . . . . . . . . . . . . . . . . . . . . . . .
$71.60
$53.70
EXHIBIT 3A–1
Maxtar Industries’ Traditional
Costing System
132
Chapter 3
traditional costing system. The unit product cost of the Premium product line is $71.60
and the unit product cost of the Standard product line is $53.70 according to this traditional
costing system.
Maxtar Industries has recently experimented with an activity-based absorption costing system that has three activity cost pools: (1) supporting direct labor; (2) setting up
machines; and (3) parts administration. The top of Exhibit 3A–2 displays basic data concerning these activity cost pools. Note that the total estimated overhead cost in these three
costs pools, $1,520,000, agrees with the total estimated overhead cost in the company’s
EXHIBIT 3A–2
Maxtar Industries’ Activity-Based
Absorption Costing System
Basic Data
Activity Cost Pools and
Activity Measures
Estimated
Overhead
Cost
Premium Standard
Supporting direct labor (DLHs) . . . . . .
Setting up machines (setups) . . . . . . .
Parts administration (part types) . . . . .
$ 800,000
480,000
240,000
100,000
600
140
Total manufacturing overhead cost . . .
$1,520,000
Expected Activity
300,000
200
60
Total
400,000
800
200
Computation of Activity Rates
Activity Cost Pools
(a)
Estimated
Overhead
Cost
(b)
Total
Expected
Activity
(a) 4 (b)
Activity
Rate
Supporting direct labor . . .
Setting up machines . . . . .
Parts administration . . . . .
$800,000
$480,000
$240,000
400,000 DLHs
800 setups
200 part types
$2 per DLH
$600 per setup
$1,200 per part type
Assigning Overhead Costs to Products
Overhead Cost for the Premium Product
(a)
Activity Cost Pools
Activity Rate
Supporting direct labor . . .
Setting up machines . . . . .
Parts administration . . . . .
$2 per DLH
$600 per setup
$1,200 per part type
(b)
Activity
(a) 3 (b)
ABC Cost
100,000 DLHs
600 setups
140 part types
$200,000
360,000
168,000
Total . . . . . . . . . . . . . . . . . .
$728,000
Overhead Cost for the Standard Product
(a)
Activity Cost Pools
Activity Rate
Supporting direct labor . .
Setting up machines . . . .
Parts administration . . . .
$2 per DLH
$600 per setup
$1,200 per part type
(b)
Activity
(a) 3 (b)
ABC Cost
300,000 DLHs
200 setups
60 part types
$600,000
120,000
72,000
Total . . . . . . . . . . . . . . . . .
$792,000
Activity-Based Absorption Costing Product Costs
Premium
Standard
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead ($728,000 4 50,000 units;
$792,000 4 200,000 units) . . . . . . . . . . . . . . . . . . . . .
$40.00
24.00
$30.00
18.00
14.56
3.96
Unit product cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$78.56
$51.96
Job-Order Costing
traditional costing system. The company’s activity-based approach simply provides an
alternative way to allocate the company’s manufacturing overhead across the two products.
The activity rates for the three activity cost pools are computed in the second table in
Exhibit 3A–2. For example, the total cost in the “setting up machines” activity cost pool,
$480,000, is divided by the total activity associated with that cost pool, 800 setups, to
determine the activity rate of $600 per setup.
The activity rates are used to allocate overhead costs to the two products in the third
table in Exhibit 3A–2. For example, the activity rate for the “setting up machines” activity cost pool, $600 per setup, is multiplied by the Premium product line’s 600 setups to
determine the $360,000 machine setup cost allocated to the Premium product line.
The table at the bottom of Exhibit 3A–2 displays the overhead costs per unit and the
activity-based unit product costs. The overhead cost per unit is determined by dividing the
total overhead cost by the number of units produced. For example, the Premium product
line’s total overhead cost of $728,000 is divided by 50,000 units to determine the $14.56
overhead cost per unit. Note that the unit product costs differ from those computed using the
company’s traditional costing system in Exhibit 3A–1. Because the activity-based approach
contains both a batch-level (setting up machines) and a product-level (parts administration)
activity cost pool, the unit product costs under the activity-based approach follow the usual
pattern in which overhead costs are shifted from the high-volume to the low-volume product. The unit product cost of the Standard product line, the high-volume product, has gone
down from $53.70 under the traditional costing system to $51.96 under activity-based costing. In contrast, the unit product cost of the Premium product line, the low-volume product,
has increased from $71.60 under the traditional costing system to $78.56 under activitybased costing. Instead of using direct labor-hours (which moves in tandem with the volume
of the production) to assign all manufacturing overhead costs to products, the activity-based
approach uses a batch-level activity measure and a product-level activity measure to assign
the batch-level and product-level activity cost pools to the two products.
Glossary (Appendix 3A)
Activity An event that causes the consumption of manufacturing overhead resources. (p. 130)
Activity-based absorption costing A costing method that assigns all manufacturing overhead
costs to products based on the activities performed to make those products. (p. 130)
Activity cost pool A “bucket” in which costs are accumulated that relate to a single activity. (p. 131)
Activity measure An allocation base that is used as the denominator for an activity cost pool. (p. 131)
Batch-level activity An activity that is performed each time a batch is handled or processed,
regardless of how many units are in the batch. The amount of resources consumed depends on
the number of batches run rather than on the number of units in the batch. (p. 131)
Product-level activity An activity that relates to specific products and typically must be carried
out regardless of how many batches are run or units of product are produced and sold. (p. 131)
Appendix 3A Exercises and Problems
All applicable exercises and problems are available with McGraw-Hill’s
Connect® Accounting.
EXERCISE 3A–1 Activity-Based Absorption Costing [LO3–8]
Fogerty Company makes two products, titanium Hubs and Sprockets. Data regarding the two
products follow:
Hubs . . . . . . . . . . . . . . . . . .
Sprockets . . . . . . . . . . . . . .
Direct
Labor-Hours
per Unit
Annual
Production
0.80
0.40
10,000 units
40,000 units
133
134
Chapter 3
Additional information about the company follows:
a. Hubs require $32 in direct materials per unit, and Sprockets require $18.
b. The direct labor wage rate is $15 per hour.
c. Hubs are more complex to manufacture than Sprockets and they require special processing.
d. The company’s activity-based absorption costing system has the following activity cost pools:
Activity Cost Pool (and Activity Measure)
Machine setups (number of setups) . . . . . . . .
Special processing (machine-hours) . . . . . . .
General factory (Direct labor-hours) . . . . . . . .
Expected Activity
Estimated
Overhead Cost
Hubs
Sprockets
Total
$72,000
$200,000
$816,000
100
5,000
8,000
300
0
16,000
400
5,000
24,000
Required:
1.
2.
Compute the activity rate for each activity cost pool.
Compute the unit product cost for Hubs and Sprockets using activity-based absorption costing.
EXERCISE 3A–2 Activity-Based Absorption Costing as an Alternative to Traditional Product Costing
[LO3–8]
Harrison Company makes two products and uses a traditional costing system in which a single
plantwide predetermined overhead rate is computed based on direct labor-hours. Data for the two
products for the upcoming year follow:
Direct materials cost per unit . . . . . . . . . . . . . . . . .
Direct labor cost per unit . . . . . . . . . . . . . . . . . . . .
Direct labor-hours per unit . . . . . . . . . . . . . . . . . .
Number of units produced . . . . . . . . . . . . . . . . . . .
Rascon
Parcel
$13.00
$6.00
0.40
20,000
$22.00
$3.00
0.20
80,000
These products are customized to some degree for specific customers.
Required:
1.
2.
The company’s manufacturing overhead costs for the year are expected to be $576,000. Using
the company’s traditional costing system, compute the unit product costs for the two products.
Management is considering an activity-based absorption costing system in which half of the
overhead would continue to be allocated on the basis of direct labor-hours and half would be
allocated on the basis of engineering design time. This time is expected to be distributed as
follows during the upcoming year:
Engineering design time (in hours) . . . . . . . . .
3.
Rascon
Parcel
Total
3,000
3,000
6,000
Compute the unit product costs for the two products using the proposed activity-based absorption costing system.
Explain why the product costs differ between the two systems.
EXERCISE 3A–3 Activity-Based Absorption Costing as an Alternative to Traditional Product Costing
[LO3–8]
Stillicum Corporation makes ultra light-weight backpacking tents. Data concerning the company’s
two product lines appear below:
Direct materials per unit . . . . . . . . . . .
Direct labor per unit . . . . . . . . . . . . . . .
Direct labor-hours per unit . . . . . . . . .
Estimated annual production . . . . . . .
Deluxe
Standard
$72.00
$12.00
1.0 DLHs
10,000 units
$53.00
$9.60
0.8 DLHs
50,000 units
Job-Order Costing
The company has a traditional costing system in which manufacturing overhead is applied to units
based on direct labor-hours. Data concerning manufacturing overhead and direct labor-hours for
the upcoming year appear below:
Estimated total manufacturing overhead . . . . . . .
Estimated total direct labor-hours . . . . . . . . . . . .
$325,000
50,000 DLHs
Required:
1.
2.
Determine the unit product costs of the Deluxe and Standard products under the company’s
traditional costing system.
The company is considering replacing its traditional costing system with an activity-based
absorption costing system that would have the following three activity cost pools:
Expected Activity
Estimated
Overhead Cost
Deluxe
Standard
Total
Supporting direct labor (direct labor-hours) . . . .
Batch setups (setups) . . . . . . . . . . . . . . . . . . . . .
Safety testing (tests) . . . . . . . . . . . . . . . . . . . . . .
$200,000
75,000
50,000
10,000
200
30
40,000
100
70
50,000
300
100
Total manufacturing overhead cost . . . . . . . . .
$325,000
Activity Cost Pools and Activity Measures
Determine the unit product costs of the Deluxe and Standard products under the activity-based
absorption costing system.
PROBLEM 3A–4 Activity-Based Absorption Costing as an Alternative to Traditional Product Costing
[LO3–8]
Ellix Company manufactures two models of ultra-high fidelity speakers, the X200 model and the
X99 model. Data regarding the two products follow:
Product
X200 . . . . . . . . . . . . . . . . . . .
X99 . . . . . . . . . . . . . . . . . . . .
Direct
Labor-Hours
Annual
Production
Total Direct
Labor-Hours
1.8 DLHs per unit
0.9 DLHs per unit
5,000 units
30,000 units
9,000 DLHs
27,000 DLHs
36,000 DLHs
Additional information about the company follows:
a. Model X200 requires $72 in direct materials per unit, and model X99 requires $50.
b. The direct labor rate is $10 per hour.
c. The company has always used direct labor-hours as the base for applying manufacturing overhead cost to products.
d. Model X200 is more complex to manufacture than model X99 and requires the use of special
equipment.
e. Because of the special work required in (d) above, the company is considering the use of
activity-based absorption costing to apply manufacturing overhead cost to products. Three
activity cost pools have been identified as follows:
Activity Cost Pool
Machine setups . . . . . . . . .
Special processing . . . . . .
General factory . . . . . . . . .
Estimated Total Activity
Activity Measure
Estimated
Total Cost
X200
X99
Total
Number of setups
Machine-hours
Direct labor-hours
$ 360,000
180,000
1,260,000
50
12,000
9,000
100
0
27,000
150
12,000
36,000
$1,800,000
135
136
Chapter 3
Required:
1.
2
3.
Assume that the company continues to use direct labor-hours as the base for applying overhead cost to products.
a. Compute the predetermined overhead rate.
b. Compute the unit product cost of each model.
Assume that the company decides to use activity-based absorption costing to apply overhead
cost to products.
a. Compute the activity rate for each activity cost pool and determine the amount of overhead cost that would be applied to each model using the activity-based approach.
b. Compute the unit product cost of each model.
Explain why overhead cost shifted from the high-volume model to the low-volume model
under the activity-based approach.
PROBLEM 3A–5 Activity-Based Absorption Costing as an Alternative to Traditional Product Costing
[LO3–8]
Siegel Company manufactures a product that is available in both a deluxe model and a regular model. The company has manufactured the regular model for years. The deluxe model
was introduced several years ago to tap a new segment of the market. Since introduction of
the deluxe model, the company’s profits have steadily declined and management has become
increasingly concerned about the accuracy of its costing system. Sales of the deluxe model have
been increasing rapidly.
Manufacturing overhead is assigned to products on the basis of direct labor-hours. For the
current year, the company has estimated that it will incur $900,000 in manufacturing overhead cost
and produce 5,000 units of the deluxe model and 40,000 units of the regular model. The deluxe
model requires two hours of direct labor time per unit, and the regular model requires one hour.
Material and labor costs per unit are as follows:
Model
Deluxe
Regular
$40
$14
$25
$7
Direct materials . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . .
Required:
1.
2.
Using direct labor-hours as the base for assigning overhead cost to products, compute the
predetermined overhead rate. Using this rate and other data from the problem, determine the
unit product cost of each model.
Management is considering using activity-based absorption costing to apply manufacturing
overhead cost to products. The activity-based system would have the following four activity
cost pools:
Activity Cost Pool
Purchasing . . . . . . . . . . . . . .
Processing . . . . . . . . . . . . .
Scrap/rework . . . . . . . . . . . .
Shipping . . . . . . . . . . . . . . .
Activity Measure
Estimated
Overhead Cost
Purchase orders issued
Machine-hours
Scrap/rework orders issued
Number of shipments
$204,000
182,000
379,000
135,000
$900,000
Expected Activity
Activity Measure
Deluxe
Regular
Total
Purchase orders issued . . . . . . . . . . . . . . . . . .
Machine-hours . . . . . . . . . . . . . . . . . . . . . . . .
Scrap/rework orders issued . . . . . . . . . . . . . . .
Number of shipments . . . . . . . . . . . . . . . . . . .
200
20,000
1,000
250
400
15,000
1,000
650
600
35,000
2,000
900
Determine the predetermined overhead rate for each of the four activity cost pools.
Job-Order Costing
3.
4.
Using the predetermined overhead rates you computed in part (2), do the following:
a. Compute the total amount of manufacturing overhead cost that would be applied to each
model using the activity-based absorption costing system. After these totals have been
computed, determine the amount of manufacturing overhead cost per unit of each model.
b. Compute the unit product cost of each model (direct materials, direct labor, and manufacturing overhead).
From the data you have developed in parts (1) through (3), identify factors that may account
for the company’s declining profits.
CASE 3A–6 Activity-Based Absorption Costing and Pricing [LO3–8]
Java Source, Inc. (JSI), is a processor and distributor of a variety of blends of coffee. The company buys coffee beans from around the world and roasts, blends, and packages them for resale.
JSI offers a large variety of different coffees that it sells to gourmet shops in one-pound bags. The
major cost of the coffee is raw materials. However, the company’s predominantly automated roasting, blending, and packing processes require a substantial amount of manufacturing overhead. The
company uses relatively little direct labor.
Some of JSI’s coffees are very popular and sell in large volumes, while a few of the newer
blends sell in very low volumes. JSI prices its coffees at manufacturing cost plus a markup of 25%,
with some adjustments made to keep the company’s prices competitive.
For the coming year, JSI’s budget includes estimated manufacturing overhead cost of
$2,200,000. JSI assigns manufacturing overhead to products on the basis of direct labor-hours.
The expected direct labor cost totals $600,000, which represents 50,000 hours of direct labor time.
Based on the sales budget and expected raw materials costs, the company will purchase and use
$5,000,000 of raw materials (mostly coffee beans) during the year.
The expected costs for direct materials and direct labor for one-pound bags of two of the company’s coffee products appear below.
Kenya Dark
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor (0.02 hours per bag) . . . . . . . . . . . . . .
Viet Select
$4.50
$0.24
$2.90
$0.24
JSI’s controller believes that the company’s traditional costing system may be providing misleading cost information. To determine whether or not this is correct, the controller has prepared
an analysis of the year’s expected manufacturing overhead costs, as shown in the following table:
Activity Cost Pool
Purchasing . . . . . . . . . . . .
Material handling . . . . . . .
Quality control . . . . . . . . .
Roasting . . . . . . . . . . . . .
Blending . . . . . . . . . . . . .
Packaging . . . . . . . . . . . .
Activity Measure
Expected Activity
for the Year
Expected Cost
for the Year
Purchase orders
Number of setups
Number of batches
Roasting hours
Blending hours
Packaging hours
2,000 orders
1,000 setups
500 batches
95,000 roasting hours
32,000 blending hours
24,000 packaging hours
$ 560,000
193,000
90,000
1,045,000
192,000
120,000
Total manufacturing
overhead cost . . . . . . .
$2,200,000
Data regarding the expected production of Kenya Dark and Viet Select coffee are presented below.
Expected sales . . . . . . . . . . . . . . . . . .
Batch size . . . . . . . . . . . . . . . . . . . . . .
Setups . . . . . . . . . . . . . . . . . . . . . . . . .
Purchase order size . . . . . . . . . . . . . . .
Roasting time per 100 pounds . . . . . .
Blending time per 100 pounds . . . . . .
Packaging time per 100 pounds . . . . .
Kenya Dark
Viet Select
80,000 pounds
5,000 pounds
2 per batch
20,000 pounds
1.5 roasting hours
0.5 blending hours
0.3 packaging hours
4,000 pounds
500 pounds
2 per batch
500 pounds
1.5 roasting hours
0.5 blending hours
0.3 packaging hours
137
138
Chapter 3
Required:
1.
2.
3.
Using direct labor-hours as the base for assigning manufacturing overhead cost to products,
do the following:
a. Determine the predetermined overhead rate that will be used during the year.
b. Determine the unit product cost of one pound of the Kenya Dark coffee and one pound of
the Viet Select coffee.
Using activity-based absorption costing as the basis for assigning manufacturing overhead
cost to products, do the following:
a. Determine the total amount of manufacturing overhead cost assigned to the Kenya Dark
coffee and to the Viet Select coffee for the year.
b. Using the data developed in (2a) above, compute the amount of manufacturing overhead
cost per pound of the Kenya Dark coffee and the Viet Select coffee. Round all computations to the nearest whole cent.
c. Determine the unit product cost of one pound of the Kenya Dark coffee and one pound of
the Viet Select coffee.
Write a brief memo to the president of JSI explaining what you have found in (1) and (2)
above and discussing the implications to the company of using direct labor as the base for
assigning manufacturing overhead cost to products.
(CMA, adapted)
Appendix 3B: The Predetermined Overhead Rate and Capacity
LO3–9
Understand the implications
of basing the predetermined
overhead rate on activity
at capacity rather than on
estimated activity for the
period.
Companies typically base their predetermined overhead rates on the estimated, or budgeted, amount of the allocation base for the upcoming period. This is the method that is
used in the chapter, but it is a practice that is often criticized based on the accounting for
fixed manufacturing overhead costs.1 As we shall see, the critics argue that, in general,
too much fixed manufacturing overhead cost is applied to products. To focus on this
issue, we will make two simplifying assumptions in this appendix: (1) we will consider
only fixed manufacturing overhead; and (2) we will assume that the actual fixed manufacturing overhead at the end of the period is the same as the estimated, or budgeted,
fixed manufacturing overhead at the beginning of the period. Neither of these assumptions is entirely realistic. Ordinarily, some manufacturing overhead is variable and even
fixed costs can differ from what was expected at the beginning of the period, but making
those assumptions enables us to focus on the primary issues the critics raise.
An example will help us to understand the controversy. Prahad Corporation manufactures music CDs for local recording studios. The company’s CD duplicating machine
is capable of producing a new CD every 10 seconds from a master CD. The company
leases the CD duplicating machine for $180,000 per year, and this is the company’s only
manufacturing overhead cost. With allowances for setups and maintenance, the machine
is theoretically capable of producing up to 900,000 CDs per year. However, due to weak
retail sales of CDs, the company’s commercial customers are unlikely to order more than
600,000 CDs next year. The company uses machine time as the allocation base for applying manufacturing overhead to CDs. These data are summarized below:
Prahad Corporation Data
Total manufacturing overhead cost . . . . . . . . . .
Allocation base—machine time per CD . . . . . .
Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Budgeted output for next year . . . . . . . . . . . . .
1
$180,000 per year
10 seconds per CD
900,000 CDs per year
600,000 CDs
Statement of Financial Accounting Standards No. 151: Inventory Costs and International Accounting
Standard 2: Inventories require allocating fixed manufacturing overhead costs to products based on normal
capacity. Normal capacity reflects the level of output expected to be produced over numerous periods under
normal circumstances. This definition mirrors the language used in this book that refers to basing the predetermined overhead rate on the estimated, or budgeted, amount of the allocation base for the upcoming period.
Job-Order Costing
If Prahad follows common practice and computes its predetermined overhead rate
using estimated or budgeted figures, then its predetermined overhead rate for next year
would be $0.03 per second of machine time computed as follows:
Predetermined _____________________________________
Estimated total manufacturing overhead cost
overhead rate 5 Estimated total amount of the allocation base
$180,000
5 _____________________________
600,000 CDs 3 10 seconds per CD
5 $0.03 per second
Because each CD requires 10 seconds of machine time, each CD will be charged for
$0.30 of overhead cost.
Critics charge that there are two problems with this procedure. First, if predetermined overhead rates are based on budgeted activity and overhead includes significant
fixed costs, then the unit product costs will fluctuate depending on the budgeted level of
activity for the period. For example, if the budgeted output for the year was only 300,000
CDs, the predetermined overhead rate would be $0.06 per second of machine time or
$0.60 per CD rather than $0.30 per CD. In general, if budgeted output falls, the overhead
cost per unit will increase; it will appear that the CDs cost more to make. Managers may
then be tempted to increase prices at the worst possible time—just as demand is falling.
Second, critics charge that under the traditional approach, products are charged for
resources that they don’t use. When the fixed costs of capacity are spread over estimated
activity, the units that are produced must shoulder the costs of unused capacity. That is
why the applied overhead cost per unit increases as the level of activity falls. The critics
argue that products should be charged only for the capacity that they use; they should
not be charged for the capacity they don’t use. This can be accomplished by basing the
predetermined overhead rate on capacity as follows:
Estimated total manufacturing overhead cost at capacity
Predetermined overhead 5 ______________________________________________
rate based on capacity
Estimated total amount of the allocation base at capacity
$180,000
5 _____________________________
900,000 CDs 3 10 seconds per CD
5 $0.02 per second
It is important to realize that the numerator in this predetermined overhead rate is the
estimated total manufacturing overhead cost at capacity. In general, the numerator in
a predetermined overhead rate is the estimated total manufacturing overhead cost for
the level of activity in the denominator. Ordinarily, the estimated total manufacturing
overhead cost at capacity will be larger than the estimated total manufacturing overhead
cost at the estimated level of activity. The estimated level of activity in this case was
600,000 CDs (or 6 million seconds of machine time), whereas capacity is 900,000 CDs
(or 9 million seconds of machine time). The estimated total manufacturing overhead cost
at 600,000 CDs was $180,000. This also happens to be the estimated total manufacturing
overhead cost at 900,000 CDs, but that only happens because we have assumed that the
manufacturing overhead is entirely fixed. If manufacturing overhead contained any variable element, the total manufacturing overhead would be larger at 900,000 CDs than at
600,000 CDs and, in that case, the predetermined overhead rate should reflect that fact.
At any rate, returning to the computation of the predetermined overhead rate based
on capacity, the predetermined overhead rate is $0.02 per second and so the overhead cost
applied to each CD would be $0.20. This charge is constant and would not be affected by
the level of activity during a period. If output falls, the charge would still be $0.20 per CD.
This method will almost certainly result in underapplied overhead. If actual output
at Prahad Corporation is 600,000 CDs, then only $120,000 of overhead cost would be
applied to products ($0.20 per CD 3 600,000 CDs). Because the actual overhead cost is
$180,000, overhead would be underapplied by $60,000. Because we are assuming that
139
140
Chapter 3
manufacturing overhead is entirely fixed and that actual manufacturing overhead equals
the manufacturing overhead as estimated at the beginning of the year, the underapplied
overhead represents the cost of unused capacity. In other words, if there had been no
unused capacity, there would have been no underapplied overhead. The critics suggest
that the underapplied overhead that results from unused capacity should be separately
disclosed on the income statement as the Cost of Unused Capacity—a period expense.
Disclosing this cost as a lump sum of $60,000 on the income statement, rather than burying it in Cost of Goods Sold or ending inventories, makes it much more visible to managers. An example of such an income statement appears below:
Prahad Corporation
Income Statement
For the Year Ended December 31
Sales1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold2 . . . . . . . . . . . . . . . . . . . .
$1,200,000
1,080,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . .
Other expenses:
Cost of unused capacity3 . . . . . . . . . . . . . .
Selling and administrative expenses4 . . . . .
120,000
Net operating loss . . . . . . . . . . . . . . . . . . . . .
$60,000
90,000
150,000
$
(30,000)
1
Assume sales of 600,000 CDs at $2 per CD.
Assume the unit product cost of the CDs is $1.80, including $0.20 for
manufacturing overhead.
3
See the calculations in the text on the prior page. Underapplied
overhead is $60,000.
4
Assume selling and administrative expenses total $90,000.
2
Appendix 3B: Exercises and Problems
All applicable exercises and problems are available with McGraw-Hill’s
Connect® Accounting.
EXERCISE 3B–1 Overhead Rate Based on Capacity [LO3–9]
Wixis Cabinets makes custom wooden cabinets for high-end stereo systems from specialty woods.
The company uses a job-order costing system. The capacity of the plant is determined by the
capacity of its constraint, which is time on the automated bandsaw that makes finely beveled cuts
in wood according to the preprogrammed specifications of each cabinet. The bandsaw can operate up to 180 hours per month. The estimated total manufacturing overhead at capacity is $14,760
per month. The company bases its predetermined overhead rate on capacity, so its predetermined
overhead rate is $82 per hour of bandsaw use.
The results of a recent month’s operations appear below:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Beginning inventories . . . . . . . . . . . . . . . . . . . .
Ending inventories . . . . . . . . . . . . . . . . . . . . . . .
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor (all variable) . . . . . . . . . . . . . . . . . .
Manufacturing overhead incurred . . . . . . . . . . .
Selling and administrative expense . . . . . . . . .
Actual hours of bandsaw use . . . . . . . . . . . . . .
$43,740
$0
$0
$5,350
$8,860
$14,220
$8,180
150
Required:
1.
2.
Prepare an income statement following the example in Appendix 3B in which any underapplied overhead is directly recorded on the income statement as an expense.
Why is overhead ordinarily underapplied when the predetermined overhead rate is based on
capacity?
Job-Order Costing
EXERCISE 3B–2 Overhead Rates and Capacity Issues [LO3–1, LO3–2, LO3–7, LO3–9]
Security Pension Services helps clients to set up and administer pension plans that are in compliance with tax laws and regulatory requirements. The firm uses a job-order costing system in which
overhead is applied to clients’ accounts on the basis of professional staff hours charged to the
accounts. Data concerning two recent years appear below:
Estimated professional staff hours
to be charged to clients’ accounts . . . . . . . . . . . . .
Estimated overhead cost . . . . . . . . . . . . . . . . . . . . . .
Professional staff hours available . . . . . . . . . . . . . . . . .
2012
2013
4,600
$310,500
6,000
4,500
$310,500
6,000
“Professional staff hours available” is a measure of the capacity of the firm. Any hours available that
are not charged to clients’ accounts represent unused capacity. All of the firm’s overhead is fixed.
Required:
1.
2.
3.
4.
Marta Brinksi is an established client whose pension plan was set up many years ago. In
both 2012 and 2013, only 2.5 hours of professional staff time were charged to Ms. Brinksi’s
account. If the company bases its predetermined overhead rate on the estimated overhead cost
and the estimated professional staff hours to be charged to clients, how much overhead cost
would have been applied to Ms. Brinksi’s account in 2012? In 2013?
Suppose that the company bases its predetermined overhead rate on the estimated overhead
cost and the estimated professional staff hours to be charged to clients as in (1) above. Also
suppose that the actual professional staff hours charged to clients’ accounts and the actual
overhead costs turn out to be exactly as estimated in both years. By how much would the
overhead be underapplied or overapplied in 2012? In 2013?
Refer back to the data concerning Ms. Brinksi in (1) above. If the company bases its predetermined overhead rate on the professional staff hours available, how much overhead cost would
have been applied to Ms. Brinksi’s account in 2012? In 2013?
Suppose that the company bases its predetermined overhead rate on the professional staff
hours available as in (3) above. Also suppose that the actual professional staff hours charged
to clients’ accounts and the actual overhead costs turn out to be exactly as estimated in both
years. By how much would the overhead be underapplied or overapplied in 2012? In 2013?
PROBLEM 3B–3 Predetermined Overhead Rate and Capacity [LO3–1, LO3–2, LO3–7, LO3–9]
Platinum Tracks, Inc., is a small audio recording studio located in Los Angeles. The company
handles work for advertising agencies—primarily for radio ads—and has a few singers and bands
as clients. Platinum Tracks handles all aspects of recording from editing to making a digital master
from which CDs can be copied. The competition in the audio recording industry in Los Angeles
has always been tough, but it has been getting even tougher over the last several years. The studio
has been losing customers to newer studios that are equipped with more up-to-date equipment and
that are able to offer very attractive prices and excellent service. Summary data concerning the last
two years of operations follow:
Estimated hours of studio service . . . . . . . . . . . . . . . .
Estimated studio overhead cost . . . . . . . . . . . . . . . . . .
Actual hours of studio service provided . . . . . . . . . . . .
Actual studio overhead cost incurred . . . . . . . . . . . . .
Hours of studio service at capacity . . . . . . . . . . . . . . .
2012
2013
1,000
$160,000
750
$160,000
1,600
800
$160,000
500
$160,000
1,600
The company applies studio overhead to recording jobs on the basis of the hours of studio service provided. For example, 40 hours of studio time were required to record, edit, and master the
Verde Baja music CD for a local Latino band. All of the studio overhead is fixed, and the actual
overhead cost incurred was exactly as estimated at the beginning of the year in both 2012 and 2013.
Required:
1.
Platinum Tracks computes its predetermined overhead rate at the beginning of each year based
on the estimated studio overhead and the estimated hours of studio service for the year. How
much overhead would have been applied to the Verde Baja job if it had been done in 2012? In
2013? By how much would overhead have been underapplied or overapplied in 2012? In 2013?
141
142
Chapter 3
2.
3.
4.
The president of Platinum Tracks has heard that some companies in the industry have changed
to a system of computing the predetermined overhead rate at the beginning of each year based
on the hours of studio service that could be provided at capacity. He would like to know what
effect this method would have on job costs. How much overhead would have been applied
using this method to the Verde Baja job if it had been done in 2012? In 2013? By how much
would overhead have been underapplied or overapplied in 2012 using this method? In 2013?
How would you interpret the underapplied or overapplied overhead that results from using
studio hours at capacity to compute the predetermined overhead rate?
What fundamental business problem is Platinum Tracks facing? Which method of computing
the predetermined overhead rate is likely to be more helpful in facing this problem? Explain.
CASE 3B–4 Ethics; Predetermined Overhead Rate and Capacity [LO3–2, LO3–7, LO3–9]
Pat Miranda, the new controller of Vault Hard Drives, Inc., has just returned from a seminar on
the choice of the activity level in the predetermined overhead rate. Even though the subject did not
sound exciting at first, she found that there were some important ideas presented that should get a
hearing at her company. After returning from the seminar, she arranged a meeting with the production manager, J. Stevens, and the assistant production manager, Marvin Washington.
Pat: I ran across an idea that I wanted to check out with both of you. It’s about the way we compute
predetermined overhead rates.
J.: We’re all ears.
Pat: We compute the predetermined overhead rate by dividing the estimated total factory overhead for
the coming year, which is all a fixed cost, by the estimated total units produced for the coming year.
Marvin: We’ve been doing that as long as I’ve been with the company.
J.: And it has been done that way at every other company I’ve worked at, except at most places they
divide by direct labor-hours.
Pat: We use units because it is simpler and we basically make one product with minor variations. But,
there’s another way to do it. Instead of basing the overhead rate on the estimated total units produced for the coming year, we could base it on the total units produced at capacity.
Marvin: Oh, the Marketing Department will love that. It will drop the costs on all of our products.
They’ll go wild over there cutting prices.
Pat: That is a worry, but I wanted to talk to both of you first before going over to Marketing.
J.: Aren’t you always going to have a lot of underapplied overhead?
Pat: That’s correct, but let me show you how we would handle it. Here’s an example based on our
budget for next year.
Budgeted (estimated) production . . . . . . . . . . . . . . . . . . . . .
Budgeted sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing cost . . . . . . . . . . . . . . . . . . . . . . . . . .
Total manufacturing overhead cost (all fixed) . . . . . . . . . . . . .
Administrative and selling expenses (all fixed) . . . . . . . . . . . .
Beginning inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
160,000 units
160,000 units
200,000 units
$60 per unit
$15 per unit
$4,000,000
$2,700,000
$0
Traditional Approach to Computation of the Predetermined Overhead Rate
Estimated total manufacturing overhead cost, $4,000,000
______________________________________________
Estimated total units produced, 160,000
5 $25 per unit
Budgeted Income Statement
Revenue (160,000 units 3 $60 per unit) . . . . . . . . . . . . . . . . . . .
Cost of goods sold:
Variable manufacturing (160,000 units 3 $15 per unit) . . . . .
Manufacturing overhead applied
(160,000 units 3 $25 per unit) . . . . . . . . . . . . . . . . . . . . . .
$9,600,000
$2,400,000
4,000,000
6,400,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . .
3,200,000
2,700,000
Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 500,000
Job-Order Costing
New Approach to Computation of the Predetermined Overhead Rate
Using Capacity in the Denominator
Estimated total manufacturing overhead cost at capacity, $4,000,000
_______________________________________________________
5 $20 per unit
Total units at capacity, 200,000
Budgeted Income Statement
Revenue (160,000 units 3 $60 per unit) . . . . . . . . . . . . . . . . .
Cost of goods sold:
Variable manufacturing (160,000 units 3 $15 per unit) . . .
Manufacturing overhead applied
(160,000 units 3 $20 per unit) . . . . . . . . . . . . . . . . . . . . .
$9,600,000
$2,400,000
3,200,000
5,600,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of unused capacity [(200,000 units 2 160,000 units)
3 $20 per unit] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . . . . . . . . . . .
4,000,000
Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 500,000
800,000
2,700,000
J.: Whoa!! I don’t think I like the looks of that “Cost of unused capacity.” If that thing shows up on
the income statement, someone from headquarters is likely to come down here looking for some
people to lay off.
Marvin: I’m worried about something else too. What happens when sales are not up to expectations?
Can we pull the “hat trick”?
Pat: I’m sorry, I don’t understand.
J.: Marvin’s talking about something that happens fairly regularly. When sales are down and profits
look like they are going to be lower than the president told the owners they were going to be, the
president comes down here and asks us to deliver some more profits.
Marvin: And we pull them out of our hat.
J.: Yeah, we just increase production until we get the profits we want.
Pat: I still don’t understand. You mean you increase sales?
J.: Nope, we increase production. We’re the production managers, not the sales managers.
Pat: I get it. Because you have produced more, the sales force has more units it can sell.
J.: Nope, the marketing people don’t do a thing. We just build inventories and that does the trick.
Required:
In all of the questions below, assume that the predetermined overhead rate under the traditional
method is $25 per unit, and under the new method it is $20 per unit. Also assume that under the
traditional method any underapplied or overapplied overhead is taken directly to the income statement as an adjustment to Cost of Goods Sold.
1. Suppose actual production is 160,000 units. Compute the net operating incomes that would
be realized under the traditional and new methods if actual sales are 150,000 units and everything else turns out as expected.
2. How many units would have to be produced under each of the methods in order to realize the
budgeted net operating income of $500,000 if actual sales are 150,000 units and everything
else turns out as expected?
3. What effect does the new method based on capacity have on the volatility of net operating
income?
4. Will the “hat trick” be easier or harder to perform if the new method based on capacity is used?
5. Do you think the “hat trick” is ethical?
143
CHAPTER 4
Process Costing
Costing the “Quicker-Picker-Upper”
BUSIN ESS FO CUS
If you have ever spilled milk,
there is a good chance that
you used Bounty paper
towels to clean up the
mess. Procter & Gamble
(P&G) manufactures Bounty
in two main processing
departments—Paper Making and Paper Converting.
In the Paper Making Department, wood pulp is converted into paper and then
spooled into 2,000 pound
rolls. In the Paper Converting Department, two of the
2,000 pound rolls of paper
are simultaneously unwound
into a machine that creates
a two-ply paper towel that is
decorated, perforated, and
embossed to create texture.
The large sheets of paper
towels that emerge from
this process are wrapped
around a cylindrical cardboard core measuring eight feet in length. Once
enough sheets wrap around the core, the eight foot roll is cut into individual
rolls of Bounty that are sent down a conveyor to be wrapped, packed, and
shipped.
In this type of manufacturing environment, costs cannot be readily traced to
individual rolls of Bounty; however, given the homogeneous nature of the product, the total costs incurred in the Paper Making Department can be spread
uniformly across its output of 2,000 pound rolls of paper. Similarly, the total
costs incurred in the Paper Converting Department (including the cost of the
2,000 pound rolls that are transferred in from the Paper Making Department)
can be spread uniformly across the number of cases of Bounty produced.
P&G uses a similar costing approach for many of its products such as
Tide, Crest toothpaste, and Dawn dishwashing liquid. ■
LEARNING OBJECTIVES
Source: Conversation with Brad Bays, formerly a Procter & Gamble financial executive.
144
After studying Chapter 4, you should be
able to:
LO4–1
Record the flow of materials, labor,
and overhead through a process
costing system.
LO4–2
Compute the equivalent units of
production using the weightedaverage method.
LO4–3
Compute the cost per equivalent unit
using the weighted-average method.
LO4–4
Assign costs to units using the
weighted-average method.
LO4–5
Prepare a cost reconciliation report.
LO4–6
(Appendix 4A) Compute the
equivalent units of production using
the FIFO method.
LO4–7
(Appendix 4A) Compute the cost per
equivalent unit using the FIFO method.
LO4–8
(Appendix 4A) Assign costs to units
using the FIFO method.
LO4–9
(Appendix 4A) Prepare a cost
reconciliation report using the FIFO
method.
LO4–10
(Appendix 4B) Allocate service
department costs to operating
departments using the direct method.
LO4–11
(Appendix 4B) Allocate service department costs to operating departments
using the step-down method.
Process Costing
ob-order costing and process costing are two common methods
for determining unit product costs. As explained in the previous chapter, job-order
costing is used when many different jobs or products are worked on each period.
Examples of industries that use job-order costing include furniture manufacturing,
special-order printing, shipbuilding, and many types of service organizations.
By contrast, process costing is used most commonly in industries that convert raw
materials into homogeneous (i.e., uniform) products, such as bricks, soda, or paper,
on a continuous basis. Examples of companies that would use process costing include
Reynolds Consumer Products (aluminum ingots), Scott Paper (paper towels), General
Mills (flour), ExxonMobil (gasoline and lubricating oils), Coppertone (sunscreens),
and Kellogg’s (breakfast cereals). In addition, process costing is sometimes used in companies with assembly operations. A form of process costing may also be used in utilities
that produce gas, water, and electricity.
Our purpose in this chapter is to explain how product costing works in a process costing system.
J
Comparison of Job-Order and Process Costing
In some ways process costing is very similar to job-order costing, and in some ways it is
very different. In this section, we focus on these similarities and differences to provide a
foundation for the detailed discussion of process costing that follows.
Similarities between Job-Order and Process Costing
Much of what you learned in the previous chapter about costing and cost flows applies
equally well to process costing in this chapter. We are not throwing out all that we have
learned about costing and starting from “scratch” with a whole new system. The similarities between job-order and process costing can be summarized as follows:
1. Both systems have the same basic purposes—to assign material, labor, and manufacturing overhead costs to products and to provide a mechanism for computing unit
product costs.
2. Both systems use the same basic manufacturing accounts, including Manufacturing
Overhead, Raw Materials, Work in Process, and Finished Goods.
3. The flow of costs through the manufacturing accounts is basically the same in both
systems.
As can be seen from this comparison, much of the knowledge that you have already
acquired about costing is applicable to a process costing system. Our task now is to refine
and extend your knowledge to process costing.
Differences between Job-Order and Process Costing
There are three differences between job-order and process costing. First, process
costing is used when a company produces a continuous flow of units that are indistinguishable from one another. Job-order costing is used when a company produces
many different jobs that have unique production requirements. Second, under process
costing, it makes no sense to try to identify materials, labor, and overhead costs with
a particular customer order (as we did with job-order costing) because each order is
just one of many that are filled from a continuous flow of virtually identical units
from the production line. Accordingly, process costing accumulates costs by department (rather than by order) and assigns these costs uniformly to all units that pass
through the department during a period. Job cost sheets (which we used for job-order
costing) are not used to accumulate costs. Third, process costing systems compute
145
146
Chapter 4
EXHIBIT 4–1
Differences between Job-Order
and Process Costing
Job-Order Costing
Process Costing
1. Many different jobs are worked
on during each period, with each
job having different production
requirements.
2. Costs are accumulated by
individual job.
3. Unit costs are computed by job on
the job cost sheet.
1. A single product is produced
either on a continuous basis or for
long periods of time. All units of
product are identical.
2. Costs are accumulated by
department.
3. Unit costs are computed
by department.
unit costs by department. This differs from job-order costing where unit costs are
computed by job on the job cost sheet. Exhibit 4–1 summarizes the differences just
described.
Cost Flows in Process Costing
Before going through a detailed example of process costing, it will be helpful to see how,
in a general way, manufacturing costs flow through a process costing system.
Processing Departments
A processing department is an organizational unit where work is performed on a product and where materials, labor, or overhead costs are added to the product. For example, a
Nalley’s potato chip factory might have three processing departments—one for preparing
potatoes, one for cooking, and one for inspecting and packaging. A brick factory might
have two processing departments—one for mixing and molding clay into brick form and
one for firing the molded brick. Some products and services may go through a number of
processing departments, while others may go through only one or two. Regardless of the
number of processing departments, they all have two essential features. First, the activity
in the processing department is performed uniformly on all of the units passing through
it. Second, the output of the processing department is homogeneous; in other words, all
of the units produced are identical.
Products in a process costing environment, such as bricks or potato chips, typically
flow in sequence from one department to another as in Exhibit 4–2.
EXHIBIT 4–2
Sequential Processing
Departments
Processing
costs
Basic raw
material
inputs
(potatoes)
Processing
Department
(potato
preparation)
Processing
costs
Partially
completed
goods
(prepared
potatoes)
Processing
Department
(cooking)
Processing
costs
Partially
completed
goods
(cooked
potato chips)
Processing
Department
(inspecting
and packing)
Finished
goods
(packaged
potato chips)
Process Costing
147
IN BUSINESS
MONKS MAKE A LIVING SELLING BEER
The Trappist monks of St. Sixtus monastery in Belgium have been brewing beer since 1839. Customers must make an appointment with the monastery to buy a maximum of two 24-bottle cases
per month. The scarce and highly prized beer sells for more than $15 per 11-ounce bottle.
The monk’s brewing ingredients include water, malt, hops, sugar, and yeast. The sequential
steps of the beer-making process include grinding and crushing the malt grain, brewing by adding
water to the crushed malt, filtering to separate a liquid called wort from undissolved grain particles,
boiling to sterilize the wort (including adding sugar to increase the density of the wort), fermentation
by adding yeast to convert sugar into alcohol and carbon dioxide, storage where the beer is aged
for at least three weeks, and bottling where more sugar and yeast are added to enable two weeks
of additional fermentation in the bottle.
Unlike growth-oriented for-profit companies, the monastery has not expanded its production
capacity since 1946, seeking instead to sell just enough beer to sustain the monks’ modest lifestyle.
Source: John W. Miller, “Trappist Command: Thou Shalt Not Buy Too Much of Our Beer,” The Wall Street Journal,
November 29, 2007, pp. A1 and A14.
The Flow of Materials, Labor, and Overhead Costs
Cost accumulation is simpler in a process costing system than in a job-order costing system. In a process costing system, instead of having to trace costs to hundreds of different
jobs, costs are traced to only a few processing departments.
A T-account model of materials, labor, and overhead cost flows in a process costing
system is shown in Exhibit 4–3. Several key points should be noted from this exhibit. First,
note that a separate Work in Process account is maintained for each processing department.
EXHIBIT 4–3
T-Account Model of Process
Costing Flows
Raw Materials
Wages Payable
Manufacturing
Overhead
Work in
Process—
Department A
XXX
Work in
Process—
Department B
XXX
XXX
Finished Goods
XXX
Cost of Goods Sold
XXX
148
Chapter 4
In contrast, in a job-order costing system the entire company may have only one Work in
Process account. Second, note that the completed production of the first processing department (Department A in the exhibit) is transferred to the Work in Process account of the
second processing department (Department B). After further work in Department B, the
completed units are then transferred to Finished Goods. (In Exhibit 4–3, we show only two
processing departments, but a company can have many processing departments.)
Finally, note that materials, labor, and overhead costs can be added in any processing department—not just the first. Costs in Department B’s Work in Process account
consist of the materials, labor, and overhead costs incurred in Department B plus the
costs attached to partially completed units transferred in from Department A (called
transferred-in costs).
Materials, Labor, and Overhead Cost Entries
LO4–1
Record the flow of materials,
labor, and overhead through a
process costing system.
To complete our discussion of cost flows in a process costing system, in this section we
show journal entries relating to materials, labor, and overhead costs at Megan’s Classic
Cream Soda, a company that has two processing departments—Formulating and Bottling.
In the Formulating Department, ingredients are checked for quality and then mixed and
injected with carbon dioxide to create bulk cream soda. In the Bottling Department,
bottles are checked for defects, filled with cream soda, capped, visually inspected again
for defects, and then packed for shipping.
Materials Costs As in job-order costing, materials are drawn from the storeroom
using a materials requisition form. Materials can be added in any processing department,
although it is not unusual for materials to be added only in the first processing department, with subsequent departments adding only labor and overhead costs.
At Megan’s Classic Cream Soda, some materials (i.e., water, flavors, sugar, and carbon dioxide) are added in the Formulating Department and some materials (i.e., bottles,
caps, and packing materials) are added in the Bottling Department. The journal entry to
record the materials used in the first processing department, the Formulating Department,
is as follows:
Work in Process—Formulating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
XXX
The journal entry to record the materials used in the second processing department, the
Bottling Department, is as follows:
Work in Process—Bottling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
XXX
Labor Costs In process costing, labor costs are traced to departments—not to
individual jobs. The following journal entry records the labor costs in the Formulating
Department at Megan’s Classic Cream Soda:
Work in Process—Formulating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
XXX
A similar entry would be made to record labor costs in the Bottling Department.
Overhead Costs In process costing, as in job-order costing, predetermined overhead rates are usually used. Manufacturing overhead cost is applied according to the
amount of the allocation base that is incurred in the department. The following journal
entry records the overhead cost applied in the Formulating Department:
Work in Process—Formulating . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
XXX
XXX
A similar entry would be made to apply manufacturing overhead costs in the Bottling
Department.
Process Costing
149
Completing the Cost Flows Once processing has been completed in a department, the units are transferred to the next department for further processing, as illustrated
in the T-accounts in Exhibit 4–3. The following journal entry transfers the cost of partially completed units from the Formulating Department to the Bottling Department:
Work in Process—Bottling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Work in Process—Formulating . . . . . . . . . . . . . . . . . . . . . . . . . . .
XXX
After processing has been completed in the Bottling Department, the costs of the
completed units are transferred to the Finished Goods inventory account:
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
XXX
Work in Process—Bottling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finally, when a customer’s order is filled and units are sold, the cost of the units is
transferred to Cost of Goods Sold:
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
XXX
To summarize, the cost flows between accounts are basically the same in a process
costing system as they are in a job-order costing system. The only difference at this point is
that in a process costing system each department has a separate Work in Process account.
THE DIFFERENCE BETWEEN LABOR RATES AND LABOR COST
IN BUSINESS
The emergence of China as a global competitor has increased the need for managers to understand the difference between labor rates and labor cost. Labor rates reflect the amount paid to
employees per hour or month. Labor costs measure the employee compensation paid per unit of
output. For example, Tenneco has plants in Shanghai, China, and Litchfield, Michigan, that both
manufacture exhaust systems for automobiles. The monthly labor rate per employee at the Shanghai plant ranges from $210–$250, whereas the same figure for the Litchfield plant ranges from
$1,880–$4,064. A naïve interpretation of these labor rates would be to automatically assume that
the Shanghai plant is the lower labor cost facility. A wiser comparison of the two plants’ labor costs
would account for the fact that the Litchfield plant produced 1.4 million exhaust systems in 2005
compared to 400,000 units at the Shanghai plant, while having only 20% more employees than the
Shanghai plant.
Source: Alex Taylor III, “A Tale of Two Factories,” Fortune, September 18, 2006, pp. 118–126.
We now turn our attention to Double Diamond Skis, a company that manufactures a
high-performance deep-powder ski, and that uses process costing to determine its unit
product costs. The company’s production process is illustrated in Exhibit 4–4. Skis go
through a sequence of five processing departments, starting with the Shaping and Milling
Department and ending with the Finishing and Pairing Department. The basic idea in process costing is to add together all of the costs incurred in a department during a period and
then to spread those costs uniformly across the units processed in that department during
that period. As we shall see, applying this simple idea involves a few complications.
Equivalent Units of Production
After materials, labor, and overhead costs have been accumulated in a department, the
department’s output must be determined so that unit product costs can be computed. The
difficulty is that a department usually has some partially completed units in its ending
150
EXHIBIT 4–4
The Production Process at Double Diamond Skis*
Graphics Application
Department
Molding
Department
X-FACTOR
X-FACTOR
X-FACTOR
X-FACTOR
X-FACTOR
X-FACTOR
Shaping and
Milling Department
X-FACTOR
X-FACTOR
X-FACTOR
Finished Goods
X-FACTOR
A skilled technician selects skis
to form a pair and adjusts the
skis’ camber.
*Adapted from Bill Gout, Jesse James Doquilo, and Studio M D, “Capped Crusaders,” Skiing, October 1993, pp. 138–144.
X-FACTOR
X-FACTOR
The semi-finished skis are tuned by stone
grinding and belt sanding. The ski edges
are beveled and polished.
Finishing and Pairing
Department
X-FACTOR
X-FACTOR
X-FACTOR
The wooden core and various layers are
stacked in a mold, polyurethane foam is
injected into the mold, and then the mold
is placed in a press that fuses the parts
together.
X-FACTOR
X-FACTOR
Grinding and Sanding
Department
Graphics are applied to the back of
clear plastic top sheets using a
heat-transfer process.
X-FACTOR
X-FACTOR
Computer-assisted milling machines
shape the wood core and aluminum sheets
that serve as the backbone of the ski.
Process Costing
151
inventory. It does not seem reasonable to count these partially completed units as equivalent to fully completed units when counting the department’s output. Therefore, these
partially completed units are translated into an equivalent number of fully completed
units. In process costing, this translation is done using the following formula:
Equivalent units 5 Number of partially completed units 3 Percentage completion
As the formula states, equivalent units is the product of the number of partially completed units and the percentage completion of those units with respect to the processing in
the department. Roughly speaking, the equivalent units is the number of complete units
that could have been obtained from the materials and effort that went into the partially
complete units.
For example, suppose the Molding Department at Double Diamond has 500 units in
its ending work in process inventory that are 60% complete with respect to processing in
the department. These 500 partially complete units are equivalent to 300 fully complete
units (500 3 60% 5 300). Therefore, the ending work in process inventory contains
300 equivalent units. These equivalent units are added to any units completed during the
period to determine the department’s output for the period—called the equivalent units
of production.
Equivalent units of production for a period can be computed in different ways. In this
chapter, we discuss the weighted-average method. In Appendix 4A, we discuss the FIFO
method. The FIFO method of process costing is a method in which equivalent units and
unit costs relate only to work done during the current period. In contrast, the weightedaverage method blends together units and costs from the current period with units and
costs from the prior period. In the weighted-average method, the equivalent units of
production for a department are the number of units transferred to the next department
(or to finished goods) plus the equivalent units in the department’s ending work in process inventory.
Weighted-Average Method
Under the weighted-average method, a department’s equivalent units are computed as
follows:
Weighted-Average Method
(a separate calculation is made for each cost category in
each processing department)
Equivalent units
Equivalent units in ending
5 Units transferred to the next 1
of production
department or to finished goods work in process inventory
Note that the computation of the equivalent units of production involves adding the number of units transferred out of the department to the equivalent units in the department’s
ending inventory. There is no need to compute the equivalent units for the units transferred out of the department—they are 100% complete with respect to the work done in
that department or they would not be transferred out. In other words, each unit transferred
out of the department is counted as one equivalent unit.
Consider the Shaping and Milling Department at Double Diamond. This department
uses computerized milling machines to precisely shape the wooden core and metal sheets
that will be used to form the backbone of the ski. (See Exhibit 4–4 for an overview of the
production process at Double Diamond.) The activity shown at the top of the next page
took place in the department in May.
The first thing to note about the activity in the Shaping and Milling Department
is the flow of units through the department. The department started with 200 units in
beginning work in process inventory. During May, 5,000 units were started into production. This made a total of 5,200 units. Of this total, 4,800 units were completed and
transferred to the next department during May and 400 units were still in the department
at the end of the month as ending work in process inventory. In general, the units in
LO4–2
Compute the equivalent units of
production using the weightedaverage method.
152
Chapter 4
Percent Complete
Shaping and Milling Department
Beginning work in process inventory . . . . . . .
Units started into production
during May . . . . . . . . . . . . . . . . . . . . . . . . .
Units completed during May and
transferred to the next department . . . . . .
Ending work in process inventory . . . . . . . . .
Units
200
Materials
Conversion
55%
30%
100%*
40%
100%*
25%
5,000
4,800
400
*We always assume that units transferred out of a department are 100% complete
with respect to the processing done in that department.
beginning work in process inventory plus the units started into production must equal
the units in ending work in process inventory plus the units completed and transferred
out. In equation form, this is:
Units in beginning work in process inventory 1 Units started into production
or transferred in 5 Units in ending work in process inventory 1 Units completed
and transferred out
Note the use of the term conversion in the table above. Conversion cost, as defined
in an earlier chapter, is direct labor cost plus manufacturing overhead cost. In process
costing, conversion cost is often treated as a single element of product cost.
Note that the beginning work in process inventory was 55% complete with respect
to materials costs and 30% complete with respect to conversion costs. This means that
55% of the materials costs required to complete the units in the department had already
been incurred. Likewise, 30% of the conversion costs required to complete the units had
already been incurred.
Two equivalent unit figures must be computed—one for materials and one for conversion. These computations are shown in Exhibit 4–5.
Note that the computations in Exhibit 4–5 ignore the fact that the units in the beginning work in process inventory were partially complete. For example, the 200 units in
beginning inventory were already 30% complete with respect to conversion costs. Nevertheless, the weighted-average method is concerned only with the 4,900 equivalent units
that are in ending inventories and in units transferred to the next department; it is not
concerned with the fact that the beginning inventory was already partially complete. In
other words, the 4,900 equivalent units computed using the weighted-average method
include work that was accomplished in prior periods. This is a key point concerning the
weighted-average method and it is easy to overlook.
EXHIBIT 4–5
Equivalent Units of Production:
Weighted-Average Method
Shaping and Milling Department
Units transferred to the next department . . . . . . . . . .
Ending work in process inventory:
Materials: 400 units 3 40% complete . . . . . . . . . . .
Conversion: 400 units 3 25% complete . . . . . . . . .
Equivalent units of production . . . . . . . . . . . . . . . . . . .
Materials
Conversion
4,800
4,800
160
_____
4,960
100
4,900
Process Costing
153
IN BUSINESS
GETTING LESS FOR THE SAME PRICE
When the prices of raw materials such as sugar and cotton increase during an economic downturn,
companies realize that they cannot pass these cost increases on to customers in the form of higher
prices. Instead, companies often respond to these circumstances by holding their prices constant
while giving customers less for their money. For example, when the price of cotton increased
Georgia-Pacific responded by decreasing the width of its Angel Soft Double Roll toilet paper from
4.27 inches to 4.00 inches. The company also reduced the number of sheets per roll from 352 to
300. Similarly, Procter & Gamble decreased the number of sheets in a roll of Charmin Ultra Soft Big
Roll from 200 to 176.
These product size reductions not only lower raw material costs, but they also reduce shipping
costs. Georgia-Pacific estimates that its smaller rolls of toilet paper enable it to transport 12–17%
more units per truck, thereby saving 345,000 gallons of gasoline per year.
Source: Beth Kowitt, “When Less is . . . Less?” Fortune, November 15, 2010, p. 21.
Beginning work
in process inventory
EXHIBIT 4–6
Visual Perspective of Equivalent
Units of Production
Double Diamond Skis
Shaping and Milling Department
Conversion Costs
(weighted-average method)
5,000 units started
200 units
30% complete
4,600 units started
and completed
400 units
25% complete
Ending work
in process inventory
4,800 units completed
Units completed and transferred
4,800
to next department
Ending work in process inventory:
100
400 units 3 25%
Equivalent units of production
4,900
Exhibit 4–6 provides another way of looking at the computation of equivalent units
of production. This exhibit depicts the equivalent units computation for conversion costs.
Study it carefully before going on.
Compute and Apply Costs
In the last section, we computed the equivalent units of production for materials and
for conversion at Double Diamond Skis. In this section we will compute the cost per
equivalent unit for materials and for conversion. We will then use these costs to value
ending work in process and finished goods inventories. Exhibit 4–7 displays all of the
data concerning May’s operations in the Shaping and Milling Department that we will
need to complete these tasks.
LO4–3
Compute the cost per
equivalent unit using the
weighted-average method.
154
EXHIBIT 4–7
Shaping and Milling Department
Data for May Operations
Chapter 4
Beginning work in process inventory:
Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Completion with respect to materials . . . . . . . . . . . . . . . . . . .
Completion with respect to conversion . . . . . . . . . . . . . . . . .
Costs in beginning work in process inventory:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total cost in beginning work in process inventory . . . . . . . . .
Units started into production during the period . . . . . . . . . . . . .
Units completed and transferred out . . . . . . . . . . . . . . . . . . . .
Costs added during the period:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total cost added during the period . . . . . . . . . . . . . . . . . . . . . .
Ending work in process inventory:
Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Completion with respect to materials . . . . . . . . . . . . . . . . . .
Completion with respect to conversion . . . . . . . . . . . . . . . . .
200
55%
30%
$ 9,600
5,575
$15,175
5,000
4,800
$368,600
350,900
$719,500
400
40%
25%
Cost per Equivalent Unit—Weighted-Average Method
In the weighted-average method, the cost per equivalent unit is computed as follows:
Weighted-Average Method
(a separate calculation is made for each cost category in each processing department)
Cost added
Cost of beginning
1
during
the period
work in process inventory
Cost per equivalent unit 5 ______________________________________
Equivalent units of production
Note that the numerator is the sum of the cost of beginning work in process inventory and
of the cost added during the period. Thus, the weighted-average method blends together
costs from the prior and current periods. That is why it is called the weighted-average
method; it averages together units and costs from both the prior and current periods.
The costs per equivalent unit for materials and for conversion are computed below
for the Shaping and Milling Department for May:
Shaping and Milling Department
Costs per Equivalent Unit
Cost of beginning work in process inventory . . . . . .
Costs added during the period . . . . . . . . . . . . . . . . .
Total cost (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Materials
$ 9,600
368,600
$378,200
Equivalent units of production
(see Exhibit 4–5) (b) . . . . . . . . . . . . . . . . . . . . . . . .
Cost per equivalent unit (a) 4 (b) . . . . . . . . . . . . . . . .
4,960
$76.25
Conversion
$ 5,575
350,900
$356,475
4,900
$72.75
Applying Costs—Weighted-Average Method
LO4–4
Assign costs to units using the
weighted-average method.
The costs per equivalent unit are used to value units in ending inventory and units
that are transferred to the next department. For example, each unit transferred out of
Double Diamond’s Shaping and Milling Department to the Graphics Application
Department, as depicted in Exhibit 4–4, will carry with it a cost of $149.00 ($76.25 for
Process Costing
155
materials cost and $72.75 for conversion cost). Because 4,800 units were transferred out
in May to the next department, the total cost assigned to those units would be $715,200
(5 4,800 units 3 $149.00 per unit).
A complete accounting of the costs of both ending work in process inventory and the
units transferred out appears below:
Shaping and Milling Department
Costs of Ending Work in Process Inventory and the Units Transferred Out
Materials Conversion
Ending work in process inventory:
Equivalent units of production (materials:
400 units 3 40% complete; conversion:
400 units 3 25% complete) (a) . . . . . . . . . . .
Cost per equivalent unit (see page 154) (b) . . . .
Cost of ending work in process inventory (a) 3 (b)
Units completed and transferred out:
Units transferred to the next department (a) . . .
Cost per equivalent unit (see above) (b) . . . . . . .
Cost of units transferred out (a) 3 (b) . . . . . . . . .
160
$76.25
$12,200
100
$72.75
$7,275
Total
$19,475
4,800
4,800
$76.25
$72.75
$366,000 $349,200 $715,200
In each case, the equivalent units are multiplied by the cost per equivalent unit to determine the cost assigned to the units. This is done for each cost category—in this case,
materials and conversion. The equivalent units for the units completed and transferred out
are simply the number of units transferred to the next department because they would not
have been transferred unless they were complete.
Cost Reconciliation Report
The costs assigned to ending work in process inventory and to the units transferred out
reconcile with the costs we started with in Exhibit 4–7 as shown below:
Shaping and Milling Department
Cost Reconciliation
Costs to be accounted for:
Cost of beginning work in process inventory (Exhibit 4–7) . . . . . . . . .
Costs added to production during the period (Exhibit 4–7) . . . . . . . . .
Total cost to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 15,175
719,500
$734,675
Costs accounted for as follows:
Cost of ending work in process inventory (see above). . . . . . . . . . . . .
Cost of units transferred out (see above) . . . . . . . . . . . . . . . . . . . . . . .
Total cost accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 19,475
715,200
$734,675
The $715,200 cost of the units transferred to the next department, Graphics Application, will be accounted for in that department as “costs transferred in.” It will be treated in
the process costing system as just another category of costs like materials or conversion
costs. The only difference is that the costs transferred in will always be 100% complete
with respect to the work done in the Graphics Applications Department. Costs are passed
on from one department to the next in this fashion, until they reach the last processing
department, Finishing and Pairing. When the products are completed in this last department, their costs are transferred to finished goods.
LO4–5
Prepare a cost reconciliation
report.
156
Chapter 4
Operation Costing
The costing systems discussed in Chapters 3 and 4 represent the two ends of a continuum.
On one end is job-order costing, which is used by companies that produce many different
products in one facility. On the other end is process costing, which is used by companies that produce homogeneous products in large quantities. Between these two extremes
there are many hybrid systems that include characteristics of both job-order and process
costing. One of these hybrids is called operation costing.
Operation costing is used in situations where products have some common characteristics and some individual characteristics. Shoes, for example, have common characteristics in that all styles involve cutting and sewing that can be done on a repetitive basis,
using the same equipment and following the same basic procedures. Shoes also have
individual characteristics—some are made of expensive leathers and others may be made
using inexpensive synthetic materials. In a situation such as this, where products have
some common characteristics but also must be processed individually, operation costing
may be used to determine product costs.
As mentioned above, operation costing is a hybrid system that employs aspects of
both job-order and process costing. Products are typically processed in batches when
operation costing is used, with each batch charged for its own specific materials. In this
sense, operation costing is similar to job-order costing. However, labor and overhead costs
are accumulated by operation or by department, and these costs are assigned to units as in
process costing. If shoes are being produced, each shoe is charged the same per unit conversion cost, regardless of the style involved, but it is charged with its specific materials
cost. Thus, the company is able to distinguish between styles in terms of materials, but it
is able to employ the simplicity of a process costing system for labor and overhead costs.
Examples of other products for which operation costing may be used include electronic
equipment (such as semiconductors), textiles, clothing, and jewelry (such as rings, bracelets,
and medallions). Products of this type are typically produced in batches, but they can vary
considerably from model to model or from style to style in terms of the cost of materials.
Summary
Process costing is used in situations where homogeneous products or services are produced on a
continuous basis. Costs flow through the manufacturing accounts in basically the same way in a
process costing system as in a job-order costing system. However, costs are accumulated by department rather than by job in process costing.
In process costing, the equivalent units of production must be determined for each cost category in each department. Under the weighted-average method, the equivalent units of production equals the number of units transferred out to the next department or to finished goods plus
the equivalent units in ending work in process inventory. The equivalent units in ending inventory
equals the product of the number of partially completed units in ending work in process inventory
and their percentage of completion with respect to the specific cost category.
Under the weighted-average method, the cost per equivalent unit for a specific cost category is
computed by adding the cost of beginning work in process inventory and the cost added during the
period and then dividing the result by the equivalent units of production. The cost per equivalent
unit is then used to value the ending work in process inventory and the units transferred out to the
next department or to finished goods.
The cost reconciliation report reconciles the cost of beginning inventory and the costs added
to production during the period to the cost of ending inventory and the cost of units transferred out.
Costs are transferred from one department to the next until the last processing department. At
that point, the cost of completed units is transferred to finished goods.
Review Problem: Process Cost Flows and Costing Units
Luxguard Home Paint Company produces exterior latex paint, which it sells in one-gallon containers. The company has two processing departments—Base Fab and Finishing. White paint,
which is used as a base for all the company’s paints, is mixed from raw ingredients in the
Process Costing
Base Fab Department. Pigments are then added to the basic white paint, the pigmented paint is
squirted under pressure into one-gallon containers, and the containers are labeled and packed
for shipping in the Finishing Department. Information relating to the company’s operations for
April follows:
a. Issued raw materials for use in production: Base Fab Department, $851,000; and Finishing
Department, $629,000.
b. Incurred direct labor costs: Base Fab Department, $330,000; and Finishing Department, $270,000.
c. Applied manufacturing overhead cost: Base Fab Department, $665,000; and Finishing Department, $405,000.
d. Transferred basic white paint from the Base Fab Department to the Finishing Department,
$1,850,000.
e. Transferred paint that had been prepared for shipping from the Finishing Department to Finished Goods, $3,200,000.
Required:
1.
2.
3.
Prepare journal entries to record items (a) through (e) above.
Post the journal entries from (1) above to T-accounts. The balance in the Base Fab Department’s Work in Process account on April 1 was $150,000; the balance in the Finishing Department’s Work in Process account was $70,000. After posting entries to the T-accounts, find the
ending balance in each department’s Work in Process account.
Determine the cost of ending work in process inventories and of units transferred out of the
Base Fab Department in April. The following additional information is available regarding
production in the Base Fab Department during April:
Production data:
Units (gallons) in process, April 1: materials 100% complete;
labor and overhead 60% complete . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units (gallons) started into production during April . . . . . . . . . . . . . . . . .
Units (gallons) completed and transferred to the
Finishing Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units (gallons) in process, April 30: materials 50% complete;
labor and overhead 25% complete . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost data:
Work in process inventory, April 1:
Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.
30,000
420,000
370,000
80,000
$
92,000
21,000
37,000
Total cost of work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 150,000
Cost added during April:
Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 851,000
330,000
665,000
Total cost added during April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,846,000
Prepare a cost reconciliation report for April.
Solution to Review Problem
1.
a.
b.
c.
d.
e.
Work in Process—Base Fab Department . . . . . . . . . . . . .
Work in Process—Finishing Department . . . . . . . . . . . .
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in Process—Base Fab Department . . . . . . . . . . . . .
Work in Process—Finishing Department . . . . . . . . . . . .
Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . .
Work in Process—Base Fab Department . . . . . . . . . . . . .
Work in Process—Finishing Department . . . . . . . . . . . . .
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . .
Work in Process—Finishing Department . . . . . . . . . . . .
Work in Process—Base Fab Department . . . . . . . . . . .
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in Process—Finishing Department . . . . . . . . . . .
851,000
629,000
1,480,000
330,000
270,000
600,000
665,000
405,000
1,070,000
1,850,000
1,850,000
3,200,000
3,200,000
157
158
Chapter 4
2.
Salaries and Wages Payable
Raw Materials
Bal.
XXX
(a)
(b)
1,480,000
Work in Process—
Base Fab Department
Bal.
(a)
(b)
(c)
150,000
851,000
330,000
665,000
Bal.
146,000
(d)
Manufacturing Overhead
1,850,000
(Various actual
costs)
Work in Process—Finishing
Department
3.
Bal.
(a)
(b)
(c)
(d)
70,000
629,000
270,000
405,000
1,850,000
Bal.
24,000
(e)
600,000
3,200,000
(c)
1,070,000
Finished Goods
Bal.
(e)
XXX
3,200,000
First, we must compute the equivalent units of production for each cost category:
Base Fab Department
Equivalent Units of Production
Materials
Units transferred to the next department . . . . . . . . . . . . . .
Ending work in process inventory (materials: 80,000 units 3
50% complete; labor: 80,000 units 3 25% complete;
overhead: 80,000 units 3 25% complete) . . . . . . . . . . . .
Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . .
Labor
Overhead
370,000
370,000
370,000
40,000
410,000
20,000
390,000
20,000
390,000
Labor
Overhead
Then we must compute the cost per equivalent unit for each cost category:
Base Fab Department
Costs per Equivalent Unit
Materials
Costs:
Cost of beginning work in process inventory . . . . . . . .
Costs added during the period . . . . . . . . . . . . . . . . . . .
Total cost (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 92,000
851,000
$943,000
$ 21,000
330,000
$351,000
$ 37,000
665,000
$702,000
Equivalent units of production (b) . . . . . . . . . . . . . . . . . . .
Cost per equivalent unit (a) 4 (b) . . . . . . . . . . . . . . . . . . . .
410,000
$2.30
390,000
$0.90
390,000
$1.80
The costs per equivalent unit can then be applied to the units in ending work in process inventory
and the units transferred out as follows:
Base Fab Department
Costs of Ending Work in Process Inventory and the Units Transferred Out
Materials
Labor
Overhead
Total
Ending work in process inventory:
Equivalent units of production . . . . . . . . . . . . . . 40,000
20,000
20,000
Cost per equivalent unit . . . . . . . . . . . . . . . . . . .
$2.30
$0.90
$1.80
Cost of ending work in process inventory . . . . . $92,000 $18,000 $36,000
$146,000
Units completed and transferred out:
Units transferred to the next department . . . . . 370,000 370,000 370,000
Cost per equivalent unit . . . . . . . . . . . . . . . . . . .
$2.30
$0.90
$1.80
Cost of units completed and transferred out . . . $851,000 $333,000 $666,000 $1,850,000
Process Costing
159
4.
Base Fab Department
Cost Reconciliation
Costs to be accounted for:
Cost of beginning work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . .
Costs added to production during the period . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 150,000
1,846,000
Total cost to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,996,000
Costs accounted for as follows:
Cost of ending work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of units transferred out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 146,000
1,850,000
Total cost accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,996,000
Glossary
Conversion cost Direct labor cost plus manufacturing overhead cost. (p. 152)
Equivalent units The product of the number of partially completed units and their percentage
of completion with respect to a particular cost. Equivalent units are the number of complete
whole units that could be obtained from the materials and effort contained in partially completed units. (p. 151)
Equivalent units of production (weighted-average method) The units transferred to the next
department (or to finished goods) during the period plus the equivalent units in the department’s ending work in process inventory. (p. 151)
FIFO method A process costing method in which equivalent units and unit costs relate only to
work done during the current period. (p. 151)
Operation costing A hybrid costing system used when products have some common characteristics and some individual characteristics. (p. 156)
Process costing A costing method used when essentially homogeneous products are produced on
a continuous basis. (p. 145)
Processing department An organizational unit where work is performed on a product and where
materials, labor, or overhead costs are added to the product. (p. 146)
Weighted-average method A process costing method that blends together units and costs from
both the current and prior periods. (p. 151)
Questions
4–1
4–2
4–3
4–4
4–5
4–6
4–7
4–8
Under what conditions would it be appropriate to use a process costing system?
In what ways are job-order and process costing similar?
Why is cost accumulation simpler in a process costing system than it is in a job-order
costing system?
How many Work in Process accounts are maintained in a company that uses process costing?
Assume that a company has two processing departments—Mixing followed by Firing.
Prepare a journal entry to show a transfer of work in process from the Mixing Department to the Firing Department.
Assume that a company has two processing departments—Mixing followed by Firing.
Explain what costs might be added to the Firing Department’s Work in Process account
during a period.
What is meant by the term equivalent units of production when the weighted-average
method is used?
Watkins Trophies, Inc., produces thousands of medallions made of bronze, silver, and
gold. The medallions are identical except for the materials used in their manufacture.
What costing system would you advise the company to use?
Multiple-choice questions are provided on the text website at www.mhhe.com/garrison15e.
160
Chapter 4
Applying Excel
Available with McGraw-Hill’s Connect® Accounting.
LO4–2, LO4–3, LO4–4,
LO4–5
The Excel worksheet form that appears below is to be used to recreate the extended example on
pages 153–155. Download the workbook containing this form from the Online Learning Center at
www.mhhe.com/garrison15e. On the website you will also receive instructions about how to use
this worksheet form.
You should proceed to the requirements below only after completing your worksheet.
Required:
1.
Check your worksheet by changing the beginning work in process inventory to 100
units, the units started into production during the period to 2,500 units, and the units in
ending work in process inventory to 200 units, keeping all of the other data the same as
in the original example. If your worksheet is operating properly, the cost per equivalent
unit for materials should now be $152.50 and the cost per equivalent unit for conversion
Process Costing
2.
161
should be $145.50. If you do not get these answers, find the errors in your worksheet and
correct them.
How much is the total cost of the units transferred out? Did it change? Why or why not?
Enter the following data from a different company into your worksheet:
Beginning work in process inventory:
Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
200
Completion with respect to materials . . . . . . . . . . . . . . . . . .
100%
Completion with respect to conversion . . . . . . . . . . . . . . . . .
20%
Costs in the beginning work in process inventory:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$2,000
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$800
Units started into production during the period . . . . . . . . . . . .
1,800
Costs added during the period:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,400
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $38,765
Ending work in process inventory:
Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
100
Completion with respect to materials . . . . . . . . . . . . . . . . . .
100%
Completion with respect to conversion . . . . . . . . . . . . . . . . .
30%
3.
What is the cost of the units transferred out?
What happens to the cost of the units transferred out in part (2) above if the percentage completion with respect to conversion for the beginning inventory is changed from 20% to 40%
and everything else remains the same? What happens to the cost per equivalent unit for conversion? Explain.
The Foundational 15
Available with McGraw-Hill’s Connect® Accounting.
Clopack Company manufactures one product that goes through one processing department
called Mixing. All raw materials are introduced at the start of work in the Mixing Department.
The company uses the weighted-average method to account for units and costs. Its Work in Process T-account for the Mixing Department for June follows (all forthcoming questions pertain
to June):
Work in Process—Mixing Department
June 1 balance
Materials
Direct labor
Overhead
June 30 balance
28,000
Completed and transferred
to Finished Goods
?
120,000
79,500
97,000
?
The June 1 work in process inventory consisted of 5,000 pounds with $16,000 in materials cost
and $12,000 in conversion cost. The June 1 work in process inventory was 100% complete
with respect to materials and 50% complete with respect to conversion. During June, 37,500
pounds were started into production. The June 30 work in process inventory consisted of 8,000
pounds that were 100% complete with respect to materials and 40% complete with respect to
conversion.
Required:
1.
2.
3.
Prepare the journal entries to record the raw materials used in production and the direct labor
cost incurred.
Prepare the journal entry to record the overhead cost applied to production.
How many units were completed and transferred to finished goods during the period?
LO4–1, LO4–2, LO4–3,
LO4–4, LO4–5
162
Chapter 4
4. Compute the equivalent units of production for materials.
5. Compute the equivalent units of production for conversion.
6. What is the amount of the cost of beginning work in process inventory plus the cost added
during the period for materials?
7. What is the amount of the cost of beginning work in process inventory plus the cost added
during the period for conversion?
8. What is the cost per equivalent unit for materials?
9. What is the cost per equivalent unit for conversion?
10. What is the cost of ending work in process inventory for materials?
11. What is the cost of ending work in process inventory for conversion?
12. What is the cost of materials transferred to finished goods?
13. What is the amount of conversion cost transferred to finished goods?
14. Prepare the journal entry to record the transfer of costs from Work in Process to Finished
Goods.
15. What is the total cost to be accounted for? What is the total cost accounted for?
Exercises
All applicable exercises are available with McGraw-Hill’s Connect® Accounting.
EXERCISE 4–1 Process Costing Journal Entries [LO4–1]
Quality Brick Company produces bricks in two processing departments—Molding and Firing.
Information relating to the company’s operations in March follows:
a. Raw materials were issued for use in production: Molding Department, $23,000; and Firing
Department, $8,000.
b. Direct labor costs were incurred: Molding Department, $12,000; and Firing Department,
$7,000.
c. Manufacturing overhead was applied: Molding Department, $25,000; and Firing Department,
$37,000.
d. Unfired, molded bricks were transferred from the Molding Department to the Firing Department. According to the company’s process costing system, the cost of the unfired, molded
bricks was $57,000.
e. Finished bricks were transferred from the Firing Department to the finished goods warehouse. According to the company’s process costing system, the cost of the finished bricks was
$103,000.
f. Finished bricks were sold to customers. According to the company’s process costing system,
the cost of the finished bricks sold was $101,000.
Required:
Prepare journal entries to record items (a) through (f) above.
EXERCISE 4–2 Computation of Equivalent Units—Weighted-Average Method [LO4–2]
Clonex Labs, Inc., uses a process costing system. The following data are available for one department for October:
Percent Completed
Work in process, October 1 . . . . . . . . . . .
Work in process, October 31 . . . . . . . . . .
Units
Materials
Conversion
30,000
15,000
65%
80%
30%
40%
The department started 175,000 units into production during the month and transferred
190,000 completed units to the next department.
Required:
Compute the equivalent units of production for October assuming that the company uses the
weighted-average method of accounting for units and costs.
Process Costing
EXERCISE 4–3 Cost per Equivalent Unit—Weighted-Average Method [LO4–3]
Superior Micro Products uses the weighted-average method in its process costing system. Data for
the Assembly Department for May appear below:
Work in process, May 1 . . . . . . . . . . . . . . . . . . . . . .
Cost added during May . . . . . . . . . . . . . . . . . . . . . .
Equivalent units of production . . . . . . . . . . . . . . . . .
Materials
Labor
Overhead
$18,000
$238,900
35,000
$5,500
$80,300
33,000
$27,500
$401,500
33,000
Required:
1.
2.
Compute the cost per equivalent unit for materials, for labor, and for overhead.
Compute the total cost per equivalent whole unit.
EXERCISE 4–4 Applying Costs to Units—Weighted-Average Method [LO4–4]
Data concerning a recent period’s activity in the Prep Department, the first processing department
in a company that uses process costing, appear below:
Materials
Conversion
2,000
$13.86
800
$4.43
Equivalent units of production in ending work in process . . . .
Cost per equivalent unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A total of 20,100 units were completed and transferred to the next processing department during
the period.
Required:
Compute the cost of the units transferred to the next department during the period and the cost of
ending work in process inventory.
EXERCISE 4–5 Cost Reconciliation Report—Weighted-Average Method [LO4–5]
Maria Am Corporation uses a process costing system. The Baking Department is one of the processing departments in its strudel manufacturing facility. In June in the Baking Department, the
cost of beginning work in process inventory was $3,570, the cost of ending work in process inventory was $2,860, and the cost added to production was $43,120.
Required:
Prepare a cost reconciliation report for the Baking Department for June.
EXERCISE 4–6 Equivalent Units—Weighted-Average Method [LO4–2]
Hielta Oy, a Finnish company, processes wood pulp for various manufacturers of paper products.
Data relating to tons of pulp processed during June are provided below:
Percent Completed
Work in process, June 1 . . . . . . . . . . . .
Work in process, June 30 . . . . . . . . . . .
Started into production during June . . .
Tons of Pulp
Materials
Labor and Overhead
20,000
30,000
190,000
90%
60%
80%
40%
Required:
1.
2.
Compute the number of tons of pulp completed and transferred out during June.
Compute the equivalent units of production for materials and for labor and overhead for June.
EXERCISE 4–7 Process Costing Journal Entries [LO4–1]
Chocolaterie de Geneve, SA, is located in a French-speaking canton in Switzerland. The company
makes chocolate truffles that are sold in popular embossed tins. The company has two processing departments—Cooking and Molding. In the Cooking Department, the raw ingredients for the
truffles are mixed and then cooked in special candy-making vats. In the Molding Department, the
melted chocolate and other ingredients from the Cooking Department are carefully poured into
163
164
Chapter 4
molds and decorative flourishes are applied by hand. After cooling, the truffles are packed for sale.
The company uses a process costing system. The T-accounts below show the flow of costs through
the two departments in April:
Work in Process—Cooking
Balance 4/1
Direct materials
Direct labor
Overhead
8,000
42,000
50,000
75,000
Transferred out
160,000
Work in Process—Molding
Balance 4/1
Transferred in
Direct labor
Overhead
4,000
160,000
36,000
45,000
Transferred out
240,000
Required:
Prepare journal entries showing the flow of costs through the two processing departments during
April.
EXERCISE 4–8 Equivalent Units and Cost per Equivalent Unit—Weighted-Average Method [LO4–2,
LO4–3, LO4–4]
Helix Corporation produces prefabricated flooring in a series of steps carried out in production
departments. All of the material that is used in the first production department is added at the beginning of processing in that department. Data for May for the first production department follow:
Percent Complete
Work in process inventory, May 1 . . . . . . . . . . . . . .
Work in process inventory, May 31 . . . . . . . . . . . . .
Units
Materials
Conversion
5,000
10,000
100%
100%
40%
30%
Materials cost in work in process inventory, May 1 . . . . . . . . . . . . .
Conversion cost in work in process inventory, May 1 . . . . . . . . . . . .
Units started into production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units transferred to the next production department . . . . . . . . . . . .
Materials cost added during May . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conversion cost added during May . . . . . . . . . . . . . . . . . . . . . . . . .
$1,500
$4,000
180,000
175,000
$54,000
$352,000
Required:
1.
2.
3.
Assume that the company uses the weighted-average method of accounting for units and
costs. Determine the equivalent units for May for the first process.
Compute the costs per equivalent unit for May for the first process.
Determine the total cost of ending work in process inventory and the total cost of units transferred to the next process in May.
EXERCISE 4–9 Equivalent Units and Cost per Equivalent Unit—Weighted-Average Method [LO4–2,
LO4–3]
Pureform, Inc., manufactures a product that passes through two departments. Data for a recent
month for the first department follow:
Work in process inventory, beginning . . . . . . .
Units started in process . . . . . . . . . . . . . . . . .
Units transferred out . . . . . . . . . . . . . . . . . . . .
Work in process inventory, ending . . . . . . . . .
Cost added during the month . . . . . . . . . . . . .
Units
Materials
Labor
Overhead
5,000
45,000
42,000
8,000
$4,320
$1,040
$1,790
$52,800
$21,500
$32,250
Process Costing
The beginning work in process inventory was 80% complete with respect to materials and
60% complete with respect to labor and overhead. The ending work in process inventory was 75%
complete with respect to materials and 50% complete with respect to labor and overhead.
Required:
Assume that the company uses the weighted-average method of accounting for units and costs.
1. Compute the equivalent units for the month for the first department.
2. Determine the costs per equivalent unit for the month.
EXERCISE 4–10 Equivalent Units—Weighted-Average Method [LO4–2]
Alaskan Fisheries, Inc., processes salmon for various distributors. Two departments are involved—
Cleaning and Packing. Data relating to pounds of salmon processed in the Cleaning Department
during July are presented below:
Percent Completed
Work in process inventory, July 1 . . . . . . . . . . . . . . . .
Work in process inventory, July 31 . . . . . . . . . . . . . . .
Pounds of
Salmon
Materials
Labor and
Overhead
20,000
25,000
100%
100%
30%
60%
A total of 380,000 pounds of salmon were started into processing during July. All materials
are added at the beginning of processing in the Cleaning Department.
Required:
Compute the equivalent units for July for both materials and labor and overhead assuming that the
company uses the weighted-average method of accounting for units.
EXERCISE 4–11 Comprehensive Exercise; Second Production Department—Weighted-Average
Method [LO4–2, LO4–3, LO4–4, LO4–5]
Scribners Corporation produces fine papers in three production departments—Pulping, Drying,
and Finishing. In the Pulping Department, raw materials such as wood fiber and rag cotton are
mechanically and chemically treated to separate their fibers. The result is a thick slurry of fibers. In
the Drying Department, the wet fibers transferred from the Pulping Department are laid down on
porous webs, pressed to remove excess liquid, and dried in ovens. In the Finishing Department, the
dried paper is coated, cut, and spooled onto reels. The company uses the weighted-average method
in its process costing system. Data for March for the Drying Department follow:
Percent Completed
Units
Work in process inventory, March 1 . . . . . . . . . . . . . . .
Work in process inventory, March 31 . . . . . . . . . . . . . .
5,000
8,000
Pulping cost in work in process inventory, March 1 . . . . . . . . . .
Conversion cost in work in process inventory, March 1 . . . . . . .
Units transferred to the next production department . . . . . . . . .
Pulping cost added during March . . . . . . . . . . . . . . . . . . . . . . . .
Conversion cost added during March . . . . . . . . . . . . . . . . . . . . .
Pulping
100%
100%
Conversion
20%
25%
$4,800
$500
157,000
$102,450
$31,300
No materials are added in the Drying Department. Pulping cost represents the costs of the wet
fibers transferred in from the Pulping Department. Wet fiber is processed in the Drying Department in batches; each unit in the above table is a batch and one batch of wet fibers produces a set
amount of dried paper that is passed on to the Finishing Department.
Required:
1.
2.
3.
4.
Determine the equivalent units for March for pulping and conversion.
Compute the costs per equivalent unit for March for pulping and conversion.
Determine the total cost of ending work in process inventory and the total cost of units transferred to the Finishing Department in March.
Prepare a cost reconciliation report for the Drying Department for March.
165
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Chapter 4
EXERCISE 4–12 Cost Assignment; Cost Reconciliation—Weighted-Average Method [LO4–2, LO4–4,
LO4–5]
Superior Micro Products uses the weighted-average method in its process costing system. During
January, the Delta Assembly Department completed its processing of 25,000 units and transferred
them to the next department. The cost of beginning inventory and the costs added during January
amounted to $599,780 in total. The ending inventory in January consisted of 3,000 units, which
were 80% complete with respect to materials and 60% complete with respect to labor and overhead. The costs per equivalent unit for the month were as follows:
Materials
Cost per equivalent unit . . . . . . . . . .
$12.50
Labor
Overhead
$3.20
$6.40
Required:
1.
2.
3.
Compute the equivalent units of materials, labor, and overhead in the ending inventory for the
month.
Compute the cost of ending inventory and of the units transferred to the next department for
January.
Prepare a cost reconciliation for January. (Note: You will not be able to break the cost to be
accounted for into the cost of beginning inventory and costs added during the month.)
Problems
All applicable problems are available with McGraw-Hill’s Connect® Accounting.
PROBLEM 4–13 Comprehensive Problem; Second Production Department—Weighted-Average Method
[LO4–2, LO4–3, LO4–4, LO4–5]
Old Country Links Inc. produces sausages in three production departments—Mixing, Casing and
Curing, and Packaging. In the Mixing Department, meats are prepared and ground and then mixed
with spices. The spiced meat mixture is then transferred to the Casing and Curing Department,
where the mixture is force-fed into casings and then hung and cured in climate-controlled smoking
chambers. In the Packaging Department, the cured sausages are sorted, packed, and labeled. The
company uses the weighted-average method in its process costing system. Data for September for
the Casing and Curing Department follow:
Percent Completed
Work in process inventory, September 1 . . . . . .
Work in process inventory, September 30 . . . . .
Units
Mixing
Materials
Conversion
1
1
100%
100%
90%
80%
80%
70%
Mixing
Materials
Conversion
$1,670
$81,460
$90
$6,006
$605
$42,490
Work in process inventory, September 1 . . . . . . . . . . . . .
Cost added during September . . . . . . . . . . . . . . . . . . . . .
Mixing cost represents the costs of the spiced meat mixture transferred in from the Mixing Department. The spiced meat mixture is processed in the Casing and Curing Department in batches; each
unit in the above table is a batch and one batch of spiced meat mixture produces a set amount of
sausages that are passed on to the Packaging Department. During September, 50 batches (i.e.,
units) were completed and transferred to the Packaging Department.
Required:
1.
2.
Determine the equivalent units for September for mixing, materials, and conversion. Do not
round off your computations.
Compute the costs per equivalent unit for September for mixing, materials, and conversion.
Process Costing
3.
4.
Determine the total cost of ending work in process inventory and the total cost of units transferred to the Packaging Department in September.
Prepare a cost reconciliation report for the Casing and Curing Department for September.
PROBLEM 4–14 Analysis of Work in Process T-account—Weighted-Average Method [LO4–1, LO4–2,
LO4–3, LO4–4]
Weston Products manufactures an industrial cleaning compound that goes through three processing departments—Grinding, Mixing, and Cooking. All raw materials are introduced at the start of
work in the Grinding Department. The Work in Process T-account for the Grinding Department for
May is given below:
Work in Process—Grinding Department
Inventory, May 1
Materials
Conversion
Inventory, May 31
21,800
Completed and transferred
to the Mixing Department
?
133,400
225,500
?
The May 1 work in process inventory consisted of 18,000 pounds with $14,600 in materials cost
and $7,200 in conversion cost. The May 1 work in process inventory was 100% complete with
respect to materials and 30% complete with respect to conversion. During May, 167,000 pounds
were started into production. The May 31 inventory consisted of 15,000 pounds that were 100%
complete with respect to materials and 60% complete with respect to conversion. The company
uses the weighted-average method to account for units and costs.
Required:
1.
2.
3.
Determine the equivalent units of production for May.
Determine the costs per equivalent unit for May.
Determine the cost of the units completed and transferred to the Mixing Department during
May.
PROBLEM 4–15 Comprehensive Problem—Weighted-Average Method [LO4–2, LO4–3, LO4–4, LO4–5]
Sunspot Beverages, Ltd., of Fiji makes blended tropical fruit drinks in two stages. Fruit juices are
extracted from fresh fruits and then blended in the Blending Department. The blended juices are
then bottled and packed for shipping in the Bottling Department. The following information pertains to the operations of the Blending Department for June.
Percent Completed
Work in process, beginning . . . . . . . . .
Started into production . . . . . . . . . . . .
Completed and transferred out . . . . . .
Work in process, ending . . . . . . . . . . .
Work in process, beginning . . . . . . . . .
Cost added during June . . . . . . . . . . .
Units
Materials
Conversion
20,000
180,000
160,000
40,000
100%
75%
100%
25%
Materials
Conversion
$25,200
$334,800
$24,800
$238,700
Required:
Assume that the company uses the weighted-average method.
1. Determine the equivalent units for June for the Blending Department.
2. Compute the costs per equivalent unit for the Blending Department.
3. Determine the total cost of ending work in process inventory and the total cost of units transferred to the Bottling Department.
4. Prepare a cost reconciliation report for the Blending Department for June.
167
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Chapter 4
PROBLEM 4–16 Comprehensive Problem—Weighted-Average Method [LO4–2, LO4–3, LO4–4, LO4–5]
Builder Products, Inc., manufactures a caulking compound that goes through three processing
stages prior to completion. Information on work in the first department, Cooking, is given below
for May:
Production data:
Pounds in process, May 1; materials 100% complete;
conversion 80% complete . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pounds started into production during May . . . . . . . . . . . . . . . . . . .
Pounds completed and transferred out . . . . . . . . . . . . . . . . . . . . . .
Pounds in process, May 31; materials 60% complete;
conversion 20% complete . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost data:
Work in process inventory, May 1: . . . . . . . . . . . . . . . . . . . . . . . . . .
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost added during May:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10,000
100,000
?
15,000
$1,500
$7,200
$154,500
$90,800
The company uses the weighted-average method.
Required:
1.
2.
3.
4.
Compute the equivalent units of production.
Compute the costs per equivalent unit for the month.
Determine the cost of ending work in process inventory and of the units transferred out to the
next department.
Prepare a cost reconciliation report for the month.
PROBLEM 4–17 Cost Flows [LO4–1]
Lubricants, Inc., produces a special kind of grease that is widely used by race car drivers. The
grease is produced in two processing departments: Refining and Blending. Raw materials are
introduced at various points in the Refining Department.
The following incomplete Work in Process account is available for the Refining Department
for March:
Work in Process—Refining Department
March 1 balance
Materials
Direct labor
Overhead
March 31 balance
38,000
Completed and transferred
to Blending
?
495,000
72,000
181,000
?
The March 1 work in process inventory in the Refining Department consists of the following
elements: materials, $25,000; direct labor, $4,000; and overhead, $9,000.
Costs incurred during March in the Blending Department were: materials used, $115,000;
direct labor, $18,000; and overhead cost applied to production, $42,000.
Required:
1.
Prepare journal entries to record the costs incurred in both the Refining Department and
Blending Department during March. Key your entries to the items (a) through (g) below.
a. Raw materials were issued for use in production.
b. Direct labor costs were incurred.
c. Manufacturing overhead costs for the entire factory were incurred, $225,000. (Credit
Accounts Payable.)
d. Manufacturing overhead cost was applied to production using a predetermined overhead
rate.
e. Units that were complete with respect to processing in the Refining Department were
transferred to the Blending Department, $740,000.
Process Costing
f.
2.
Units that were complete with respect to processing in the Blending Department were
transferred to Finished Goods, $950,000.
g. Completed units were sold on account, $1,500,000. The Cost of Goods Sold was
$900,000.
Post the journal entries from (1) above to T-accounts. The following account balances existed
at the beginning of March. (The beginning balance in the Refining Department’s Work in
Process account is given on the prior page.)
Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in Process—Blending Department . . . . . . . . . . .
Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$618,000
$65,000
$20,000
After posting the entries to the T-accounts, find the ending balance in the inventory accounts and
the manufacturing overhead account.
PROBLEM 4–18 Interpreting a Report—Weighted-Average Method [LO4–2, LO4–3, LO4–4]
Cooperative San José of southern Sonora state in Mexico makes a unique syrup using cane sugar
and local herbs. The syrup is sold in small bottles and is prized as a flavoring for drinks and for use
in desserts. The bottles are sold for $12 each. The first stage in the production process is carried
out in the Mixing Department, which removes foreign matter from the raw materials and mixes
them in the proper proportions in large vats. The company uses the weighted-average method in its
process costing system.
A hastily prepared report for the Mixing Department for April appears below:
Units to be accounted for:
Work in process, April 1 (materials 90% complete;
conversion 80% complete) . . . . . . . . . . . . . . . . . . . . . . . . . .
Started into production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
30,000
200,000
Total units to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . .
230,000
Units accounted for as follows:
Transferred to next department . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process, April 30 (materials 75% complete;
conversion 60% complete) . . . . . . . . . . . . . . . . . . . . . . . . . .
190,000
40,000
Total units accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
230,000
Cost Reconciliation
Cost to be accounted for:
Work in process, April 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost added during the month . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 98,000
827,000
Total cost to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . .
$925,000
Cost accounted for as follows:
Work in process, April 30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transferred to next department . . . . . . . . . . . . . . . . . . . . . . . . .
$119,400
805,600
Total cost accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$925,000
Management would like some additional information about Cooperative San José’s operations.
Required:
1.
2.
3.
4.
What were the equivalent units for the month?
What were the costs per equivalent unit for the month? The beginning inventory consisted of
the following costs: materials, $67,800; and conversion cost, $30,200. The costs added during
the month consisted of: materials, $579,000; and conversion cost, $248,000.
How many of the units transferred to the next department were started and completed during
the month?
The manager of the Mixing Department stated, “Materials prices jumped from about $2.50
per unit in March to $3 per unit in April, but due to good cost control I was able to hold our
materials cost to less than $3 per unit for the month.” Should this manager be rewarded for
good cost control? Explain.
169
170
Chapter 4
Cases
All applicable cases are available with McGraw-Hill’s Connect® Accounting.
CASE 4–19 Second Department—Weighted-Average Method [LO4–2, LO4–3, LO4–4]
“I think we goofed when we hired that new assistant controller,” said Ruth Scarpino, president
of Provost Industries. “Just look at this report that he prepared for last month for the Finishing
Department. I can’t understand it.”
Finishing Department costs:
Work in process inventory, April 1, 450 units; materials
100% complete; conversion 60% complete . . . . . . . . . . . . . . . . . . . . .
Costs transferred in during the month from the
preceding department, 1,950 units . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Materials cost added during the month . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conversion costs incurred during the month . . . . . . . . . . . . . . . . . . . . . .
$ 8,208*
17,940
6,210
13,920
Total departmental costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$46,278
Finishing Department costs assigned to:
Units completed and transferred to finished goods,
1,800 units at $25.71 per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process inventory, April 30, 600 units;
materials 0% complete; conversion 35% complete . . . . . . . . . . . . . . .
$46,278
Total departmental costs assigned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$46,278
0
*Consists of cost transferred in, $4,068; materials cost, $1,980; and conversion
cost, $2,160.
“He’s struggling to learn our system,” replied Frank Harrop, the operations manager. “The
problem is that he’s been away from process costing for a long time, and it’s coming back slowly.”
“It’s not just the format of his report that I’m concerned about. Look at that $25.71 unit cost
that he’s come up with for April. Doesn’t that seem high to you?” said Ms. Scarpino.
“Yes, it does seem high; but on the other hand, I know we had an increase in materials prices
during April, and that may be the explanation,” replied Mr. Harrop. “I’ll get someone else to redo
this report and then we may be able to see what’s going on.”
Provost Industries manufactures a ceramic product that goes through two processing
departments—Molding and Finishing. The company uses the weighted-average method in its process costing.
Required:
1.
2.
Prepare a report for the Finishing Department showing how much cost should have been
assigned to the units completed and transferred to finished goods, and how much cost should
have been assigned to ending work in process inventory in the Finishing Department.
Explain to the president why the unit cost on the new assistant controller’s report is so high.
CASE 4–20 Ethics and the Manager, Understanding the Impact of Percentage Completion on
Profit—Weighted-Average Method [LO4–2, LO4–3, LO4–4]
Gary Stevens and Mary James are production managers in the Consumer Electronics Division of
General Electronics Company, which has several dozen plants scattered in locations throughout
the world. Mary manages the plant located in Des Moines, Iowa, while Gary manages the plant in
El Segundo, California. Production managers are paid a salary and get an additional bonus equal
to 5% of their base salary if the entire division meets or exceeds its target profits for the year. The
bonus is determined in March after the company’s annual report has been prepared and issued to
stockholders.
Shortly after the beginning of the new year, Mary received a phone call from Gary that went
like this:
Gary: How’s it going, Mary?
Mary: Fine, Gary. How’s it going with you?
Process Costing
171
Gary: Great! I just got the preliminary profit figures for the division for last year and we are within
$200,000 of making the year’s target profits. All we have to do is pull a few strings, and we’ll be
over the top!
Mary: What do you mean?
Gary: Well, one thing that would be easy to change is your estimate of the percentage completion of
your ending work in process inventories.
Mary: I don’t know if I can do that, Gary. Those percentage completion figures are supplied by Tom
Winthrop, my lead supervisor, who I have always trusted to provide us with good estimates.
Besides, I have already sent the percentage completion figures to corporate headquarters.
Gary: You can always tell them there was a mistake. Think about it, Mary. All of us managers are doing
as much as we can to pull this bonus out of the hat. You may not want the bonus check, but the rest
of us sure could use it.
The final processing department in Mary’s production facility began the year with no work
in process inventories. During the year, 210,000 units were transferred in from the prior processing department and 200,000 units were completed and sold. Costs transferred in from the prior
department totaled $39,375,000. No materials are added in the final processing department. A
total of $20,807,500 of conversion cost was incurred in the final processing department during
the year.
Required:
1.
2.
3.
4.
Tom Winthrop estimated that the units in ending inventory in the final processing department
were 30% complete with respect to the conversion costs of the final processing department. If
this estimate of the percentage completion is used, what would be the Cost of Goods Sold for
the year?
Does Gary Stevens want the estimated percentage completion to be increased or decreased?
Explain why.
What percentage completion would result in increasing reported net operating income by
$200,000 over the net operating income that would be reported if the 30% figure were used?
Do you think Mary James should go along with the request to alter estimates of the percentage
completion? Why or why not?
Appendix 4A: FIFO Method
The FIFO method of process costing differs from the weighted-average method in two
ways: (1) the computation of equivalent units, and (2) the way in which costs of beginning inventory are treated. The FIFO method is generally considered more accurate than
the weighted-average method, but it is more complex. The complexity is not a problem
for computers, but the FIFO method is a little more difficult to understand and to learn
than the weighted-average method.
Equivalent Units—FIFO Method
The computation of equivalent units under the FIFO method differs from the computation
under the weighted-average method in two ways.
First, the “units transferred out” is divided into two parts. One part consists of the
units from the beginning inventory that were completed and transferred out, and the other
part consists of the units that were both started and completed during the current period.
Second, full consideration is given to the amount of work expended during the current period on units in the beginning work in process inventory as well as on units in the
ending inventory. Thus, under the FIFO method, both beginning and ending inventories
are converted to an equivalent units basis. For the beginning inventory, the equivalent
units represent the work done to complete the units; for the ending inventory, the equivalent units represent the work done to bring the units to a stage of partial completion at the
end of the period (the same as with the weighted-average method).
LO4–6
Compute the equivalent units
of production using the FIFO
method.
172
Chapter 4
The formula for computing the equivalent units of production under the FIFO method
is more complex than under the weighted-average method:
FIFO Method
(a separate calculation is made for each cost category
in each processing department)
Equivalent units of production 5 Equivalent units to complete beginning work in process
inventory*
1 Units started and completed during the period
1 Equivalent units in ending work in process inventory
(
*Equivalent units to
Units in beginning
Percentage completion
complete beginning work 5 work in process 3 100% 2 of beginning work in
in process inventory
inventory
process inventory
)
Or, the equivalent units of production can also be determined as follows:
Equivalent units of production 5 Units transferred out
1 Equivalent units in ending work in process
inventory
2 Equivalent units in beginning work in process
inventory
To illustrate the FIFO method, refer again to the data for the Shaping and Milling Department at Double Diamond Skis. The department completed and transferred
4,800 units to the Graphics Application Department during May. Because 200 of these
units came from the beginning inventory, the Shaping and Milling Department must
have started and completed 4,600 units during May. The 200 units in the beginning
inventory were 55% complete with respect to materials and only 30% complete with
respect to conversion costs when the month started. Thus, to complete these units the
department must have added another 45% of materials costs (100% 2 55% 5 45%) and
another 70% of conversion costs (100% 2 30% 5 70%). Following this line of reasoning, the equivalent units for the department for May would be computed as shown in
Exhibit 4A–1.
EXHIBIT 4A–1
Equivalent Units of Production:
FIFO Method
Materials
To complete beginning work in process inventory:
Materials: 200 units 3 (100% 2 55%)* . . . . . . . . . . .
Conversion: 200 units 3 (100% 2 30%)* . . . . . . . . .
Units started and completed during the period . . . . . .
Ending work in process inventory:
Materials: 400 units 3 40% complete . . . . . . . . . . . .
Conversion: 400 units 3 25% complete . . . . . . . . . .
Equivalent units of production . . . . . . . . . . . . . . . . . . . .
Conversion
90
4,600†
140
4,600†
160
_____
4,850
100
4,840
*This is the work needed to complete the units in beginning inventory.
†
5,000 units started 2 400 units in ending work in process 5 4,600 units started
and completed. This can also be computed as 4,800 units completed and transferred to the next department 2 200 units in beginning work in process inventory.
The FIFO method assumes that the units in beginning inventory are finished first.
Process Costing
173
Comparison of Equivalent Units of Production under the
Weighted-Average and FIFO Methods
Stop at this point and compare the data in Exhibit 4A–1 with the data in Exhibit 4–5 in
the chapter, which shows the computation of equivalent units under the weighted-average
method. Also refer to Exhibit 4A–2, which compares the two methods.
The essential difference between the two methods is that the weighted-average
method blends work and costs from the prior period with work and costs in the current
period, whereas the FIFO method separates the two periods. To see this more clearly,
consider the following reconciliation of the two calculations of equivalent units:
Shaping and Milling Department
Materials
Equivalent units—weighted-average method . . . . . . . . . . .
Less equivalent units in beginning work in process inventory:
200 units 3 55% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
200 units 3 30% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equivalent units of production—FIFO method . . . . . . . . . .
Conversion
4,960
4,900
110
_____
4,850
60
4,840
Double Diamond Skis
Shaping and Milling Department
Conversion Costs
EXHIBIT 4A–2
Visual Perspective of
Equivalent Units of Production
Weighted-Average Method
Beginning work
in process inventory
200 units
30% complete
5,000 units started
4,600 units started and completed
Units completed and
transferred to next department
Ending work in process inventory:
400 units 3 25%
Equivalent units of production
400 units
25% complete
Ending work
in process inventory
400 units
25% complete
Ending work
in process inventory
4,800
100
4,900
FIFO Method
Beginning work
in process inventory
200 units
30% complete
5,000 units started
4,600 units started and completed
Beginning work in process
inventory:
200 units 3 70%*
Units started and completed
Ending work in process inventory:
400 units 3 25%
Equivalent units of production
140
4,600
100
4,840
* 100% 2 30% 5 70%. This 70% represents the work needed to complete the units in
the beginning inventory.
174
Chapter 4
As shown in the reconciliation of the two costing methods, it is evident that the FIFO
method removes the equivalent units that were already in beginning inventory from the
equivalent units as defined using the weighted-average method. Thus, the FIFO method
isolates the equivalent units that are due to work performed during the current period.
The weighted-average method blends together the equivalent units already in beginning
inventory with the equivalent units that are due to work performed in the current period.
Cost per Equivalent Unit—FIFO Method
LO4–7
Compute the cost per
equivalent unit using the FIFO
method.
In the FIFO method, the cost per equivalent unit is computed as follows:
FIFO Method
(a separate calculation is made for each cost category in
each processing department)
Cost added during the period
Cost per equivalent unit 5 _________________________
Equivalent units of production
Unlike the weighted-average method, in the FIFO method the cost per equivalent unit is
based only on the costs incurred in the department in the current period.
The costs per equivalent unit for materials and for conversion are computed below
for the Shaping and Milling Department for May:
Shaping and Milling Department
Costs per Equivalent Unit—FIFO method
Materials
Cost added during the period (a) . . . . . . . . . $368,600
Equivalent units of production (b) . . . . . . . . .
4,850
Cost per equivalent unit (a) 4 (b) . . . . . . . . . .
$76.00
Conversion
$350,900
4,840
$72.50
Applying Costs—FIFO Method
LO4–8
Assign costs to units using the
FIFO method.
The costs per equivalent unit are used to value units in ending inventory and units that are
transferred to the next department. For example, each unit transferred out of the Shaping
and Milling Department to the Graphics Application Department will carry with it a cost
of $148.50—$76.00 for materials cost and $72.50 for conversion cost. Because 4,800
units were transferred out in May to the next department, the total cost assigned to those
units would be $712,800 (4,800 units 3 $148.50 per unit).
A complete accounting of the costs of both ending work in process inventory and the
units transferred out appears on the next page. It is more complicated than the weightedaverage method. This is because the cost of the units transferred out consists of three
separate components: (1) the cost of beginning work in process inventory; (2) the cost
to complete the units in beginning work in process inventory; and (3) the cost of units
started and completed during the period.
Again, note that the cost of the units transferred out consists of three distinct
components—the cost of beginning work in process inventory, the cost to complete
the units in beginning inventory, and the cost of units started and completed during the period. This is a major difference between the weighted-average and FIFO
methods.
Process Costing
175
Shaping and Milling Department
Costs of Ending Work in Process Inventory and Units Transferred Out—FIFO Method
Materials Conversion
Ending work in process inventory:
Equivalent units of production
160
100
(see Exhibit 4A–1) (a) . . . . . . . . . . . . . . . . . . . .
$76.00
$72.50
Cost per equivalent unit (see page 174) (b) . . . . .
Cost of ending work in process inventory
$7,250
(a) 3 (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,160
Units transferred out:
$9,600
Cost in beginning work in process inventory . . .
Cost to complete the units in beginning work in
process inventory:
Equivalent units of production required to
complete the units in beginning inventory
90
(see Exhibit 4A–1) (a) . . . . . . . . . . . . . . . . . .
$76.00
Cost per equivalent unit (see page 174) (b) . . .
Cost to complete the units in beginning
inventory (a) 3 (b) . . . . . . . . . . . . . . . . . . . . .
$6,840
Cost of units started and completed this period:
Units started and completed this period
4,600
(see Exhibit 4A–1) (a) . . . . . . . . . . . . . . . . . .
$76.00
Cost per equivalent unit (see page 174) (b) . . .
Cost of units started and completed this period
(a) 3 (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $349,600
$5,575
Total
$19,410
$15,175
140
$72.50
$10,150
$16,990
4,600
$72.50
$333,500
Total cost of units transferred out . . . . . . . . . . . . . .
$ 683,100
$715,265
Cost Reconciliation Report—FIFO Method
The costs assigned to ending work in process inventory and to the units transferred out
reconcile with the costs we started with in Exhibit 4–7 as shown below:
Shaping and Milling Department
Cost Reconciliation
Costs to be accounted for:
Cost of beginning work in process inventory (Exhibit 4–7) . . . . $ 15,175
Costs added to production during the period (Exhibit 4–7) . . . . 719,500
Total cost to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . $734,675
Costs accounted for as follows:
Cost of ending work in process inventory (see above) . . . . . . . $ 19,410
Cost of units transferred out (see above) . . . . . . . . . . . . . . . . . . 715,265
Total cost accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $734,675
The $715,265 cost of the units transferred to the next department, Graphics Application, will be accounted for in that department as “costs transferred in.” As in the weightedaverage method, this cost will be treated in the process costing system as just another
category of costs, like materials or conversion costs. The only difference is that the costs
transferred in will always be 100% complete with respect to the work done in the Graphics Applications Department. Costs are passed on from one department to the next in this
fashion, until they reach the last processing department, Finishing and Pairing. When the
products are completed in this last department, their costs are transferred to finished goods.
LO4–9
Prepare a cost reconciliation
report using the FIFO method.
176
Chapter 4
A Comparison of Costing Methods
In most situations, the weighted-average and FIFO methods will produce very similar unit
costs. If there never are any ending inventories, the two methods will produce identical
results. The reason for this is that without any ending inventories, no costs can be carried
forward into the next period and the weighted-average method will base unit costs on just
the current period’s costs—just as in the FIFO method. If there are ending inventories, either
erratic input prices or erratic production levels would also be required to generate much of
a difference in unit costs under the two methods. This is because the weighted-average
method will blend the unit costs from the prior period with the unit costs of the current
period. Unless these unit costs differ greatly, the blending will not make much difference.
Nevertheless, from the standpoint of cost control, the FIFO method is superior to
the weighted-average method. Current performance should be evaluated based on costs
of the current period only but the weighted-average method mixes costs of the current
period with costs of the prior period. Thus, under the weighted-average method, the manager’s apparent performance in the current period is influenced by what happened in
the prior period. This problem does not arise under the FIFO method because the FIFO
method makes a clear distinction between costs of prior periods and costs incurred during
the current period. For the same reason, the FIFO method also provides more up-to-date
cost data for decision-making purposes.
On the other hand, the weighted-average method is simpler to apply than the FIFO
method, but computers can handle the additional calculations with ease once they have
been appropriately programmed.
Appendix 4A Exercises and Problems
All applicable exercises and problems are available with McGraw-Hill’s Connect®
Accounting.
EXERCISE 4A–1 Computation of Equivalent Units—FIFO Method [LO4–6]
Refer to the data for Clonex Labs, Inc., in Exercise 4–2.
Required:
Compute the equivalent units of production for October assuming that the company uses the FIFO
method of accounting for units and costs.
EXERCISE 4A–2 Cost per Equivalent Unit—FIFO Method [LO4–7]
Superior Micro Products uses the FIFO method in its process costing system. Data for the Assembly Department for May appear below:
Cost added during May . . . . . . . . . . . . . . .
Equivalent units of production . . . . . . . . . .
Materials
Labor
Overhead
$193,320
27,000
$62,000
25,000
$310,000
25,000
Required:
Compute the cost per equivalent unit for materials, labor, overhead, and in total.
EXERCISE 4A–3 Applying Costs to Units—FIFO Method [LO4–8]
Data concerning a recent period’s activity in the Assembly Department, the first processing department in a company that uses process costing, appear below:
Materials Conversion
Cost of work in process inventory at the beginning of the period . . . . .
Equivalent units of production in the ending work in process inventory . . .
Equivalent units of production required to complete the beginning
work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost per equivalent unit for the period . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,200
400
$650
200
600
$2.32
1,200
$0.75
Process Costing
A total of 26,000 units were completed and transferred to the next processing department during
the period. Beginning work in process inventory consisted of 2,000 units and ending work in process inventory consisted of 1,000 units.
Required:
Using the FIFO method, compute the cost of the units transferred to the next department during the
period and the cost of ending work in process inventory.
EXERCISE 4A–4 Cost Reconciliation Report—FIFO Method [LO4–9]
Schroeder Baking Corporation uses a process costing system in its large-scale baking operations.
The Mixing Department is one of the company’s processing departments. In the Mixing Department in July, the cost of beginning work in process inventory was $1,460, the cost of ending work
in process inventory was $3,120, and the cost added to production was $36,540.
Required:
Prepare a cost reconciliation report for the Mixing Department for July.
EXERCISE 4A–5 Computation of Equivalent Units—FIFO Method [LO4–6]
MediSecure, Inc., produces clear plastic containers for pharmacies in a process that starts in the
Molding Department. Data concerning that department’s operations in the most recent period
appear below:
Beginning work in process:
Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Completion with respect to materials . . . . . . . . . . . . . . . . . . . . .
Completion with respect to conversion . . . . . . . . . . . . . . . . . . . .
Units started into production during the month . . . . . . . . . . . . . . .
Units completed and transferred out . . . . . . . . . . . . . . . . . . . . . . .
Ending work in process:
Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Completion with respect to materials . . . . . . . . . . . . . . . . . . . . .
Completion with respect to conversion . . . . . . . . . . . . . . . . . . . .
500
80%
40%
153,600
153,700
400
75%
20%
Required:
MediSecure uses the FIFO method in its process costing system. Compute the equivalent units of
production for the period for the Molding Department.
EXERCISE 4A–6 Equivalent Units—FIFO Method [LO4–6]
Refer to the data for Alaskan Fisheries, Inc., in Exercise 4–10.
Required:
Compute the equivalent units for July for the Cleaning Department assuming that the company
uses the FIFO method of accounting for units.
EXERCISE 4A–7 Equivalent Units and Cost per Equivalent Unit—FIFO Method [LO4–6, LO4–7]
Refer to the data for Pureform, Inc., in Exercise 4–9.
Required:
Assume that the company uses the FIFO method of accounting for units and costs.
1. Compute the equivalent units for the month for the first processing department.
2. Determine the costs per equivalent unit for the month.
EXERCISE 4A–8 Equivalent Units—FIFO Method [LO4–6]
Refer to the data for Hielta Oy in Exercise 4–6. Assume that the company uses the FIFO method
in its process costing system.
Required:
1.
2.
Compute the number of tons of pulp completed and transferred out during June.
Compute the equivalent units of production for materials and for labor and overhead for
June.
177
178
Chapter 4
EXERCISE 4A–9 Equivalent Units; Applying Costs—FIFO Method [LO4–6, LO4–7, LO4–8]
Jarvene Corporation uses the FIFO method in its process costing system. The following data are
for the most recent month of operations in one of the company’s processing departments:
Units in beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . .
Units started into production . . . . . . . . . . . . . . . . . . . . . . . . .
Units in ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units transferred to the next department . . . . . . . . . . . . . . . .
Percentage completion of beginning inventory . . . . . .
Percentage completion of ending inventory . . . . . . . .
400
3,000
300
3,100
Materials
Conversion
80%
70%
40%
60%
The cost of beginning inventory according to the company’s costing system was $11,040 of which
$8,120 was for materials and the remainder was for conversion cost. The costs added during the
month amounted to $132,730. The costs per equivalent unit for the month were:
Cost per equivalent unit . . . . . . . . . . . . . . . . . . . . .
Materials
Conversion
$25.40
$18.20
Required:
1.
2.
3.
4.
5.
Compute the total cost per equivalent unit for the month.
Compute the equivalent units of material and of conversion in the ending inventory.
Compute the equivalent units of material and of conversion that were required to complete the
beginning inventory.
Determine the number of units started and completed during the month.
Determine the costs of ending inventory and units transferred out.
PROBLEM 4A–10 Equivalent Units; Applying Costs; Cost Reconciliation Report—FIFO Method [LO4–6,
LO4–7, LO4–8, LO4–9]
Selzik Company makes super-premium cake mixes that go through two processing departments,
Blending and Packaging. The following activity was recorded in the Blending Department during July:
Production data:
Units in process, July 1 (materials 100% complete; conversion 30% complete) . . .
10,000
Units started into production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170,000
Units in process, July 31 (materials 100% complete; conversion 40% complete) . . .
20,000
Cost data:
Work in process inventory, July 1:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$8,500
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$4,900
Cost added during the month:
Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $139,400
Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $244,200
All materials are added at the beginning of work in the Blending Department. The company uses
the FIFO method in its process costing system.
Required:
1.
2.
3.
4.
Determine the equivalent units for July for the Blending Department.
Compute the costs per equivalent unit for July for the Blending Department.
Determine the total cost of ending work in process inventory and the total cost of units transferred to the next process for the Blending Department in July.
Prepare a cost reconciliation report for the Blending Department for July.
Process Costing
PROBLEM 4A–11 Equivalent Units; Cost per Equivalent Unit; Applying Costs—FIFO Method [LO4–6,
LO4–7, LO4–8, LO4–9]
Refer to the data for the Blending Department of Sunspots Beverages, Ltd., in Problem 4–15.
Assume that the company uses the FIFO method rather than the weighted-average method in its
process costing system.
Required:
1.
2.
3.
4.
Determine the equivalent units for June for the Blending Department.
Compute the costs per equivalent unit for June for the Blending Department.
Determine the total cost of ending work in process inventory and the total cost of units transferred to the next process for the Blending Department in June.
Prepare a cost reconciliation report for the Blending Department for June.
CASE 4A–12 Second Department—FIFO Method [LO4–6, LO4–7, LO4–8]
Refer to the data for Provost Industries in Case 4–19. Assume that the company uses the FIFO
method in its process costing system.
Required:
1.
2.
Prepare a report for the Finishing Department for April showing how much cost should have
been assigned to the units completed and transferred to finished goods and how much cost
should have been assigned to the ending work in process inventory.
As stated in the case, the company experienced an increase in materials prices during April.
Would the effects of this price increase tend to show up more under the weighted-average
method or under the FIFO method? Why?
Appendix 4B: Service Department Allocations
Most large organizations have both operating departments and service departments.
The central purposes of the organization are carried out in the operating departments.
In contrast, service departments do not directly engage in operating activities. Instead,
they provide services or assistance to the operating departments. Examples of operating departments include the Surgery Department at Mt. Sinai Hospital, the Geography
Department at the University of Washington, the Marketing Department at Allstate
Insurance Company, and production departments at manufacturers such as Mitsubishi,
Hewlett-Packard, and Michelin. In process costing, the processing departments are
all operating departments. Examples of service departments include Cafeteria, Internal
Auditing, Human Resources, Cost Accounting, and Purchasing.
The overhead costs of operating departments commonly include allocations of costs
from the service departments. To the extent that service department costs are classified
as production costs, they should be included in unit product costs and thus, must be allocated to operating departments in a process costing system.
Three approaches are used to allocate the costs of service departments to other
departments: the direct method, the step-down method, and the reciprocal method. These
three methods are discussed in the following sections. However, before getting into the
details of these methods, we will discuss interdepartmental services.
Interdepartmental Services Many service departments provide services to
each other, as well as to operating departments. For example, the Cafeteria Department
provides meals for all employees, including those assigned to other service departments, as well as to employees of the operating departments. In turn, the Cafeteria
Department may receive services from other service departments, such as from
Custodial Services or from Personnel. Services provided between service departments
are known as interdepartmental or reciprocal services.
179
180
Chapter 4
Direct Method
LO4–10
Allocate service department
costs to operating departments
using the direct method.
The direct method is the simplest of the three cost allocation methods. It ignores the
services provided by a service department to other service departments (e.g., interdepartmental services) and allocates all service department costs directly to operating
departments. Even if a service department (such as Personnel) provides a large amount
of service to another service department (such as the cafeteria), no allocations are made
between the two departments. Rather, all costs are allocated directly to the operating
departments, bypassing the other service departments; hence, the term direct method.
For an example of the direct method, consider Mountain View Hospital, which has
two service departments and two operating departments as shown below. The hospital
allocates its Hospital Administration costs on the basis of employee-hours and its
Custodial Services costs on the basis of square feet occupied.
Service
Operating
Departments
Departments
Hospital
Custodial
Patient
Administration Services Laboratory
Care
Departmental
costs before
allocation . . . . . . .
Employee hours . . .
Space occupied—
square feet . . . . . .
$360,000
12,000
$90,000
6,000
$261,000
18,000
10,000
200
5,000
Total
$689,000 $1,400,000
30,000
66,000
45,000
60,200
The direct method of allocating the hospital’s service department costs to the operating
departments is shown in Exhibit 4B–1. Several things should be noted in this exhibit. First,
the employee-hours of the Hospital Administration Department and the Custodial Services
Department are ignored when allocating the costs of Hospital Administration using the
direct method. Under the direct method, any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable
to the operating departments is used in the allocation. Note that the same rule is used when
allocating the costs of the Custodial Services Department. Even though the Hospital Administration and Custodial Services departments occupy some space, this is ignored when the
Custodial Services costs are allocated. Finally, note that after all allocations have been completed, all of the service department costs are contained in the two operating departments.
EXHIBIT 4B–1
Direct Method of Allocation
Service
Departments
Departmental costs before allocation . . . . . . . . . .
Allocation:
Hospital Administration costs (18 ⁄48, 30 ⁄48)* . . . . .
Custodial Services costs (5 ⁄50, 45 ⁄50)† . . . . . . . . .
Total cost after allocation . . . . . . . . . . . . . . . . . . .
Operating
Departments
Hospital
Administration
Custodial
Services
Laboratory
Patient
Care
Total
$360,000
$90,000
$261,000
$689,000
$1,400,000
135,000
9,000
225,000
81,000
$405,000
$995,000
(360,000)
(90,000)
$
0
$
0
$1,400,000
*Based on the employee-hours in the two operating departments, which are 18,000 hours 1 30,000 hours 5 48,000 hours.
†
Based on the square feet occupied by the two operating departments, which is 5,000 square feet 1 45,000 square feet 5
50,000 square feet.
Process Costing
181
Although the direct method is simple, it is less accurate than the other methods
because it ignores interdepartmental services.
Step-Down Method
LO4–11
Unlike the direct method, the step-down method provides for allocation of a service
department’s costs to other service departments, as well as to operating departments.
The step-down method is sequential. The sequence typically begins with the department
that provides the greatest amount of service to other service departments. After its costs
have been allocated, the process continues, step by step, ending with the department that
provides the least amount of services to other service departments. This step procedure is
illustrated in Exhibit 4B–2.
Exhibit 4B–3 shows the details of the step-down method. Note the following three
key points about these allocations. First, under Allocation in Exhibit 4B–3, you see two
allocations, or steps. In the first step, the costs of Hospital Administration are allocated
Allocate service department
costs to operating departments
using the step-down method.
EXHIBIT 4B–2
Graphic Illustration—Step-Down
Method
Hospital
Administration
Costs are allocated to other
departments on the basis
of employee-hours.
Custodial
Services
Costs are allocated to
operating departments
on the basis of square
feet occupied.
Laboratory
Patient Care
EXHIBIT 4B–3
Step-Down Method of Allocation
Service
Departments
Departmental costs before allocation . . . . . . . . .
Allocation:
Hospital Administration costs (6⁄54, 18 ⁄54, 30 ⁄54)* . .
Custodial Services costs (5 ⁄50, 45 ⁄50)† . . . . . . . . .
Total cost after allocation . . . . . . . . . . . . . . . . . . .
Operating
Departments
Hospital
Administration
Custodial
Services
Laboratory
$360,000
$ 90,000
$261,000
$ 689,000 $1,400,000
(360,000)
40,000
(130,000)
$
0
120,000
13,000
$394,000
200,000
117,000
$1,006,000 $1,400,000
$
0
Patient
Care
Total
*Based on the employee-hours in Custodial Services and the two operating departments, which are 6,000 hours 1
18,000 hours 1 30,000 hours 5 54,000 hours.
As in Exhibit 4B–1, this allocation is based on the square feet occupied by the two operating departments.
182
Chapter 4
to another service department (Custodial Services) as well as to the operating departments. In contrast to the direct method, the allocation base for Hospital Administration
costs now includes the employee-hours for Custodial Services as well as for the operating departments. However, the allocation base still excludes the employee-hours for
Hospital Administration itself. In both the direct and step-down methods, any amount
of the allocation base attributable to the service department whose cost is being allocated is always ignored. Second, looking again at Exhibit 4B–3, note that in the second
step under the Allocation heading, the cost of Custodial Services is allocated to the two
operating departments, and none of the cost is allocated to Hospital Administration even
though Hospital Administration occupies space in the building. In the step-down method,
any amount of the allocation base that is attributable to a service department whose cost
has already been allocated is ignored. After a service department’s costs have been allocated, costs of other service departments are not reallocated back to it. Third, note that the
cost of Custodial Services allocated to other departments in the second step ($130,000) in
Exhibit 4B–3 includes the costs of Hospital Administration that were allocated to Custodial Services in the first step in Exhibit 4B–3.
Reciprocal Method
The reciprocal method gives full recognition to interdepartmental services. Under the
step-down method only partial recognition of interdepartmental services is possible.
The step-down method always allocates costs forward—never backward. The reciprocal
method, by contrast, allocates service department costs in both directions. Thus, because
Custodial Services in the prior example provides services for Hospital Administration,
part of Custodial Services’ costs will be allocated back to Hospital Administration if
the reciprocal method is used. At the same time, part of Hospital Administration’s costs
will be allocated forward to Custodial Services. Reciprocal allocation requires the use
of simultaneous linear equations and is beyond the scope of this book. Examples of the
reciprocal method can be found in more advanced cost accounting texts.
Appendix 4B Exercises and Problems
All applicable exercises and problems are available with McGraw-Hill’s Connect®
Accounting.
EXERCISE 4B–1 Direct Method [LO4–10]
Seattle Western University has provided the following data to be used in its service department cost
allocations:
Service Departments
Departmental costs before
allocations . . . . . . . . . . . . .
Student credit-hours . . . . . . .
Space occupied—square feet
Operating Departments
Administration
Facility
Services
Undergraduate
Programs
Graduate
Programs
$2,400,000
$1,600,000
25,000
10,000
$26,800,000
20,000
70,000
$5,700,000
5,000
30,000
Required:
Using the direct method, allocate the costs of the service departments to the two operating departments. Allocate the costs of Administration on the basis of student credit-hours and Facility Services costs on the basis of space occupied.
Process Costing
183
EXERCISE 4B–2 Step-Down Method [LO4–11]
Madison Park Co-op, a whole foods grocery and gift shop, has provided the following data to be
used in its service department cost allocations:
Service Departments
Administration
Departmental costs before allocations . . .
Employee-hours . . . . . . . . . . . . . . . . . . .
Space occupied—square feet . . . . . . . .
$150,000
320
250
Operating Departments
Janitorial
Groceries
Gifts
$40,000
160
100
$2,320,000
3,100
4,000
$950,000
740
1,000
Required:
Using the step-down method, allocate the costs of the service departments to the two operating
departments. Allocate Administration first on the basis of employee-hours and then Janitorial on
the basis of space occupied.
EXERCISE 4B–3 Step-Down Method [LO4–11]
The Ferre Publishing Company has three service departments and two operating departments.
Selected data from a recent period on the five departments follow:
Service Departments
Operating Departments
Administration
Janitorial
Maintenance
Binding
Printing
Total
$140,000
60
15,000
$105,000
35
10,000
$48,000
140
20,000
$275,000
315
40,000
30,000
$430,000
210
100,000
60,000
$998,000
760
185,000
90,000
Costs . . . . . . . . . . . . . . . . . . . . . . . .
Number of employees . . . . . . . . . .
Square feet of space occupied . . . .
Hours of press time . . . . . . . . . . . .
The company allocates service department costs by the step-down method in the following order:
Administration (number of employees), Janitorial (space occupied), and Maintenance (hours of
press time).
Required:
Using the step-down method, allocate the service department costs to the operating departments.
EXERCISE 4B–4 Direct Method [LO4–10]
Refer to the data for the Ferre Publishing Company in Exercise 4B–3.
Required:
Assuming that the company uses the direct method rather than the step-down method to allocate
service department costs, how much cost would be assigned to each operating department?
PROBLEM 4B–5 Step-Down Method [LO4–11]
Woodbury Hospital has three service departments and three operating departments. Estimated cost
and operating data for all departments in the hospital for the forthcoming quarter are presented in
the table below:
Service Departments
Housekeeping
Services
Operating Departments
Food
Services
Admin.
Services
Laboratory
Radiology
General
Hospital
Total
Variable costs . . . . . . . . . . . . . . .
Fixed costs . . . . . . . . . . . . . . . . .
$
0
87,000
$193,860
107,200
$158,840
90,180
$243,600
162,300
$304,800
215,700
$ 74,500
401,300
$ 975,600
1,063,680
Total cost . . . . . . . . . . . . . . . . . .
$87,000
$301,060
$249,020
$405,900
$520,500
$475,800
$2,039,280
800
2,000
1,000
68,000
71,800
0.8%
6,500
2.4%
10,000
14,000
1.6%
7,500
7,000
95.2%
108,000
25,000
100%
150,000
46,000
30%
20%
50%
100%
Meals served . . . . . . . . . . . . . . . .
Percentage of peak-period
needs—Food Services . . . . . .
Square feet of space . . . . . . . . . .
Files processed . . . . . . . . . . . . . .
Percentage of peak-period
needs—Admin. Services . . . . .
5,000
13,000
184
Chapter 4
The costs of the service departments are allocated by the step-down method using the allocation
bases and in the order shown in the following table:
Service Department
Housekeeping Services . . . . . . . . . .
Food Services . . . . . . . . . . . . . . . . . .
Administrative Services . . . . . . . . . .
Costs
Incurred
Allocation Bases
Fixed
Variable
Fixed
Variable
Fixed
Square feet of space
Meals served
Peak-period needs—Food Services
Files processed
Peak-period needs—Admin. Services
All billing in the hospital is done through Laboratory, Radiology, or General Hospital. The hospital’s administrator wants the costs of the three service departments allocated to these three billing
centers.
Required:
Using the step-down method, prepare the cost allocation desired by the hospital administrator.
Include under each billing center the direct costs of the center, as well as the costs allocated from
the service departments.
PROBLEM 4B–6 Step-Down Method versus Direct Method; Predetermined Overhead Rates [LO4–10,
LO4–11]
The Sendai Co., Ltd., of Japan has budgeted costs in its various departments as follows for the
coming year:
Factory Administration . . . . . . . . . . . . . . . . .
Custodial Services . . . . . . . . . . . . . . . . . . . . .
Personnel . . . . . . . . . . . . . . . . . . . . . . . . . . .
Maintenance . . . . . . . . . . . . . . . . . . . . . . . . .
Machining—overhead . . . . . . . . . . . . . . . . . .
Assembly—overhead . . . . . . . . . . . . . . . . . .
$270,000
68,760
28,840
45,200
376,300
175,900
Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$965,000
The company allocates service department costs to other departments in the order listed below.
Department
Factory Administration . . . .
Custodial Services . . . . . .
Personnel . . . . . . . . . . . . .
Maintenance . . . . . . . . . . .
Machining . . . . . . . . . . . . .
Assembly . . . . . . . . . . . . .
Number of
Employees
Total
LaborHours
Square
Feet of
Space
Occupied
Direct
LaborHours
MachineHours
12
4
5
25
40
60
—
3,000
5,000
22,000
30,000
90,000
5,000
2,000
3,000
10,000
70,000
20,000
—
—
—
—
20,000
80,000
—
—
—
—
70,000
10,000
146
150,000
110,000
100,000
80,000
Machining and Assembly are operating departments; the other departments are service departments. Factory Administration is allocated on the basis of labor-hours; Custodial Services on the
basis of square feet occupied; Personnel on the basis of number of employees; and Maintenance on
the basis of machine-hours.
Required:
1.
Allocate service department costs to consuming departments by the step-down method. Then
compute predetermined overhead rates in the operating departments using a machine-hours
basis in Machining and a direct labor-hours basis in Assembly.
Process Costing
2.
3.
4.
Repeat (1) above, this time using the direct method. Again compute predetermined overhead
rates in Machining and Assembly.
Assume that the company doesn’t bother with allocating service department costs but simply
computes a single plantwide overhead rate based on total overhead costs (both service department and operating department costs) divided by total direct labor-hours. Compute the plantwide overhead rate.
Suppose a job requires machine and labor time as follows:
MachineHours
Direct
Labor-Hours
Machining Department . . . . . . . .
Assembly Department . . . . . . . . .
190
10
25
75
Total hours . . . . . . . . . . . . . . . . . .
200
100
Using the overhead rates computed in (1), (2), and (3) above, compute the amount of overhead
cost that would be assigned to the job if the overhead rates were developed using the stepdown method, the direct method, and the plantwide method.
CASE 4B–7 Step-Down Method versus Direct Method [LO4–10, LO4–11]
“This is really an odd situation,” said Jim Carter, general manager of Highland Publishing Company. “We get most of the jobs we bid on that require a lot of press time in the Printing Department,
yet profits on those jobs are never as high as they ought to be. On the other hand, we lose most of
the jobs we bid on that require a lot of time in the Binding Department. I would be inclined to think
that the problem is with our overhead rates, but we’re already computing separate overhead rates
for each department. So what else could be wrong?”
Highland Publishing Company is a large organization that offers a variety of printing and
binding work. The Printing and Binding departments are supported by three service departments.
The costs of these service departments are allocated to other departments in the order listed below.
(For each service department, use the allocation base that provides the best measure of service
provided, as discussed in the chapter.)
Department
Total
LaborHours
Square Feet
of Space
Occupied
Number
of
Employees
MachineHours
Direct
LaborHours
Personnel . . . . . . . . .
Custodial Services . . .
Maintenance . . . . . . .
Printing . . . . . . . . . . .
Binding . . . . . . . . . . .
20,000
30,000
50,000
90,000
260,000
4,000
6,000
20,000
80,000
40,000
10
15
25
40
120
150,000
30,000
60,000
175,000
450,000
150,000
210
180,000
235,000
Budgeted overhead costs in each department for the current year are shown below:
Personnel . . . . . . . . . . . . . . . .
Custodial Services . . . . . . . . . .
Maintenance . . . . . . . . . . . . . .
Printing . . . . . . . . . . . . . . . . . .
Binding . . . . . . . . . . . . . . . . . .
$ 360,000
141,000
201,000
525,000
373,500
Total budgeted cost . . . . . . . . .
$1,600,500
Because of its simplicity, the company has always used the direct method to allocate service
department costs to the two operating departments.
185
186
Chapter 4
Required:
1.
2.
3.
Using the step-down method, allocate the service department costs to the consuming departments. Then compute predetermined overhead rates for the current year using machine-hours
as the allocation base in the Printing Department and direct labor-hours as the allocation base
in the Binding Department.
Repeat (1) above, this time using the direct method. Again compute predetermined overhead
rates in the Printing and Binding departments.
Assume that during the current year the company bids on a job that requires machine and
labor time as follows:
a.
b.
MachineHours
Direct
Labor-Hours
Printing Department . . . . . . . . .
Binding Department . . . . . . . . .
15,400
800
900
2,000
Total hours . . . . . . . . . . . . . . . . .
16,200
2,900
Determine the amount of overhead cost that would be assigned to the job if the company
used the overhead rates developed in (1) above. Then determine the amount of overhead
cost that would be assigned to the job if the company used the overhead rates developed
in (2) above.
Explain to Mr. Carter, the general manager, why the step-down method provides a better
basis for computing predetermined overhead rates than the direct method.
CHAPTER 5
Cost-Volume-Profit Relationships
Moreno Turns Around the Los Angeles Angels
BUSIN ESS FO CUS
LEARNING OBJECTIVES
After studying Chapter 5, you should be
able to:
LO5–1
Explain how changes in activity affect
contribution margin and net operating
income.
LO5–2
Prepare and interpret a cost-volumeprofit (CVP) graph and a profit graph.
LO5–3
Use the contribution margin ratio (CM
ratio) to compute changes in contribution
margin and net operating income
resulting from changes in sales volume.
When Arturo Moreno bought Major League Baseball’s Los Angeles Angels
in 2003, the team was drawing 2.3 million fans and losing $5.5 million per
year. Moreno immediately cut prices to attract more fans and increase profits. In his first spring training game, he reduced the price of selected tickets
from $12 to $6. By increasing attendance, Moreno understood that he would
sell more food and souvenirs. He dropped the price of draft beer by $2 and
cut the price of baseball caps from $20 to $7.
The Angels now consistently draw about 3.4 million fans per year.
This growth in attendance helped double stadium sponsorship revenue to
$26 million, and it motivated the Fox Sports Network to pay the Angels
$500 million to broadcast all of its games for the next ten years. Since
Moreno bought the Angels, annual revenues have jumped from $127 million
to $212 million, and the team’s operating loss of $5.5 million has been transformed to a profit of $10.3 million. ■
LO5–4
Show the effects on net operating
income of changes in variable costs,
fixed costs, selling price, and volume.
LO5–5
Determine the break-even point.
LO5–6
Determine the level of sales needed to
achieve a desired target profit.
LO5–7
Compute the margin of safety and
explain its significance.
LO5–8
Compute the degree of operating
leverage at a particular level of sales
and explain how it can be used to predict
changes in net operating income.
Source: Matthew Craft, “Moreno’s Math,” Forbes, May 11, 2009, pp. 84–87.
LO5–9
Compute the break-even point for a
multiproduct company and explain
the effects of shifts in the sales
mix on contribution margin and the
break-even point.
187
188
Chapter 5
ost-volume-profit (CVP) analysis helps managers make many
C
important decisions such as what products and services to offer, what prices to
charge, what marketing strategy to use, and what cost structure to maintain. Its primary purpose is to estimate how profits are affected by the following five factors:
1.
2.
3.
4.
5.
Selling prices.
Sales volume.
Unit variable costs.
Total fixed costs.
Mix of products sold.
To simplify CVP calculations, managers typically adopt the following assumptions
with respect to these factors1:
1. Selling price is constant. The price of a product or service will not change as volume
changes.
2. Costs are linear and can be accurately divided into variable and fixed elements. The
variable element is constant per unit. The fixed element is constant in total over the
entire relevant range.
3. In multiproduct companies, the mix of products sold remains constant.
While these assumptions may be violated in practice, the results of CVP analysis
are often “good enough” to be quite useful. Perhaps the greatest danger lies in relying on
simple CVP analysis when a manager is contemplating a large change in sales volume
that lies outside the relevant range. However, even in these situations the CVP model can
be adjusted to take into account anticipated changes in selling prices, variable costs per
unit, total fixed costs, and the sales mix that arise when the estimated sales volume falls
outside the relevant range.
To help explain the role of CVP analysis in business decisions, we’ll now turn our
attention to the case of Acoustic Concepts, Inc., a company founded by Prem Narayan.
MANAGERIAL
ACCOUNTING IN ACTION
THE ISSUE
Prem, who was a graduate student in engineering at the time, started Acoustic Concepts
to market a radical new speaker he had designed for automobile sound systems. The
speaker, called the Sonic Blaster, uses an advanced microprocessor and proprietary software to boost amplification to awesome levels. Prem contracted with a Taiwanese electronics manufacturer to produce the speaker. With seed money provided by his family,
Prem placed an order with the manufacturer and ran advertisements in auto magazines.
The Sonic Blaster was an immediate success, and sales grew to the point that Prem
moved the company’s headquarters out of his apartment and into rented quarters in a
nearby industrial park. He also hired a receptionist, an accountant, a sales manager, and
a small sales staff to sell the speakers to retail stores. The accountant, Bob Luchinni,
had worked for several small companies where he had acted as a business advisor as
well as accountant and bookkeeper. The following discussion occurred soon after Bob
was hired:
Prem: Bob, I’ve got a lot of questions about the company’s finances that I hope you can
help answer.
Bob: We’re in great shape. The loan from your family will be paid off within a few
months.
Prem: I know, but I am worried about the risks I’ve taken on by expanding operations.
What would happen if a competitor entered the market and our sales slipped? How
far could sales drop without putting us into the red? Another question I’ve been trying to resolve is how much our sales would have to increase to justify the big marketing campaign the sales staff is pushing for.
Bob: Marketing always wants more money for advertising.
1
One additional assumption often used in manufacturing companies is that inventories do not change.
The number of units produced equals the number of units sold.
Cost-Volume-Profit Relationships
189
Prem: And they are always pushing me to drop the selling price on the speaker. I
agree with them that a lower price will boost our sales volume, but I’m not sure the
increased volume will offset the loss in revenue from the lower price.
Bob: It sounds like these questions are all related in some way to the relationships
among our selling prices, our costs, and our volume. I shouldn’t have a problem coming up with some answers.
Prem: Can we meet again in a couple of days to see what you have come up with?
Bob: Sounds good. By then I’ll have some preliminary answers for you as well as a
model you can use for answering similar questions in the future.
The Basics of Cost-Volume-Profit (CVP) Analysis
Bob Luchinni’s preparation for his forthcoming meeting with Prem begins with the contribution income statement. The contribution income statement emphasizes the behavior
of costs and therefore is extremely helpful to managers in judging the impact on profits
of changes in selling price, cost, or volume. Bob will base his analysis on the following
contribution income statement he prepared last month:
Acoustic Concepts, Inc.
Contribution Income Statement
For the Month of June
Sales (400 speakers) . . . . . . . . . .
Variable expenses . . . . . . . . . . . .
Contribution margin . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . .
Net operating income . . . . . . . . . .
Total
$100,000
60,000
40,000
35,000
$ 5,000
Per Unit
$250
150
$100
Notice that sales, variable expenses, and contribution margin are expressed on a per
unit basis as well as in total on this contribution income statement. The per unit figures
will be very helpful to Bob in some of his calculations. Note that this contribution income
statement has been prepared for management’s use inside the company and would not
ordinarily be made available to those outside the company.
Contribution Margin
Contribution margin is the amount remaining from sales revenue after variable expenses
have been deducted. Thus, it is the amount available to cover fixed expenses and then to
provide profits for the period. Notice the sequence here—contribution margin is used first
to cover the fixed expenses, and then whatever remains goes toward profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. To
illustrate with an extreme example, assume that Acoustic Concepts sells only one speaker
during a particular month. The company’s income statement would appear as follows:
Contribution Income Statement
Sales of 1 Speaker
Sales (1 speaker) . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . .
Contribution margin . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . .
Net operating loss . . . . . . . . . . . .
Total
$
250
150
100
35,000
$(34,900)
Per Unit
$250
150
$100
LO5–1
Explain how changes in activity
affect contribution margin and
net operating income.
190
Chapter 5
For each additional speaker the company sells during the month, $100 more in contribution margin becomes available to help cover the fixed expenses. If a second speaker
is sold, for example, then the total contribution margin will increase by $100 (to a total of
$200) and the company’s loss will decrease by $100, to $34,800:
Contribution Income Statement
Sales of 2 Speakers
Sales (2 speakers) . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . .
Contribution margin . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . .
Net operating loss . . . . . . . . . . . .
Total
500
300
200
35,000
$(34,800)
$
Per Unit
$250
150
$100
If enough speakers can be sold to generate $35,000 in contribution margin, then all of
the fixed expenses will be covered and the company will break even for the month—that
is, it will show neither profit nor loss but just cover all of its costs. To reach the breakeven point, the company will have to sell 350 speakers in a month because each speaker
sold yields $100 in contribution margin:
Contribution Income Statement
Sales of 350 Speakers
Sales (350 speakers) . . . . . . . . . .
Variable expenses . . . . . . . . . . . .
Contribution margin . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . .
Net operating income . . . . . . . . . .
Total
$87,500
52,500
35,000
35,000
$
0
Per Unit
$250
150
$100
Computation of the break-even point is discussed in detail later in the chapter; for
the moment, note that the break-even point is the level of sales at which profit is zero.
Once the break-even point has been reached, net operating income will increase by
the amount of the unit contribution margin for each additional unit sold. For example,
if 351 speakers are sold in a month, then the net operating income for the month will be
$100 because the company will have sold 1 speaker more than the number needed to
break even:
Contribution Income Statement
Sales of 351 Speakers
Sales (351 speakers) . . . . . . . . . .
Variable expenses . . . . . . . . . . . .
Contribution margin . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . .
Net operating income . . . . . . . . . .
Total
$87,750
52,650
35,100
35,000
$ 100
Per Unit
$250
150
$100
If 352 speakers are sold (2 speakers above the break-even point), the net operating income for the month will be $200. If 353 speakers are sold (3 speakers above the
break-even point), the net operating income for the month will be $300, and so forth. To
estimate the profit at any sales volume above the break-even point, multiply the number
of units sold in excess of the break-even point by the unit contribution margin. The result
Cost-Volume-Profit Relationships
represents the anticipated profits for the period. Or, to estimate the effect of a planned
increase in sales on profits, simply multiply the increase in units sold by the unit contribution margin. The result will be the expected increase in profits. To illustrate, if Acoustic
Concepts is currently selling 400 speakers per month and plans to increase sales to 425
speakers per month, the anticipated impact on profits can be computed as follows:
Increased number of speakers to be sold . . . . .
Contribution margin per speaker . . . . . . . . . . . .
Increase in net operating income . . . . . . . . . . .
25
3 $100
$ 2,500
These calculations can be verified as follows:
Sales Volume
Sales (@ $250 per speaker) . . . . . .
Variable expenses
(@ $150 per speaker) . . . . . . . . .
Contribution margin . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . .
400
Speakers
425
Speakers
Difference
(25 Speakers)
$100,000
$106,250
$6,250
$250
60,000
40,000
35,000
$ 5,000
63,750
42,500
35,000
$ 7,500
3,750
2,500
0
$2,500
150
$100
Per Unit
To summarize, if sales are zero, the company’s loss would equal its fixed expenses.
Each unit that is sold reduces the loss by the amount of the unit contribution margin.
Once the break-even point has been reached, each additional unit sold increases the company’s profit by the amount of the unit contribution margin.
CVP Relationships in Equation Form
The contribution format income statement can be expressed in equation form as follows:
Profit 5 (Sales 2 Variable expenses) 2 Fixed expenses
For brevity, we use the term profit to stand for net operating income in equations.
When a company has only a single product, as at Acoustic Concepts, we can further
refine the equation as follows:
Sales 5 Selling price per unit 3 Quantity sold 5 P 3 Q
Variable expenses 5 Variable expenses per unit 3 Quantity sold 5 V 3 Q
Profit 5 (P 3 Q 2 V 3 Q) 2 Fixed expenses
We can do all of the calculations of the previous section using this simple equation.
For example, on the previous page we computed that the net operating income (profit)
at sales of 351 speakers would be $100. We can arrive at the same conclusion using the
above equation as follows:
Profit 5 (P 3 Q 2 V 3 Q) 2 Fixed expenses
Profit 5 ($250 3 351 2 $150 3 351) 2 $35,000
5 ($250 2 $150) 3 351 2 $35,000
5 ($100) 3 351 2 $35,000
5 $35,100 2 $35,000 5 $100
191
192
Chapter 5
It is often useful to express the simple profit equation in terms of the unit contribution margin (Unit CM) as follows:
Unit CM 5 Selling price per unit 2 Variable expenses per unit 5 P 2 V
Profit 5 (P 3 Q 2 V 3 Q) 2 Fixed expenses
Profit 5 (P 2 V) 3 Q 2 Fixed expenses
Profit 5 Unit CM 3 Q 2 Fixed expenses
We could also have used this equation to determine the profit at sales of 351 speakers as
follows:
Profit 5 Unit CM 3 Q 2 Fixed expenses
5 $100 3 351 2 $35,000
5 $35,100 2 $35,000 5 $100
For those who are comfortable with algebra, the quickest and easiest approach to
solving the problems in this chapter may be to use the simple profit equation in one of
its forms.
CVP Relationships in Graphic Form
LO5–2
Prepare and interpret a costvolume-profit (CVP) graph and a
profit graph.
The relationships among revenue, cost, profit, and volume are illustrated on a costvolume-profit (CVP) graph. A CVP graph highlights CVP relationships over wide
ranges of activity. To help explain his analysis to Prem Narayan, Bob Luchinni prepared
a CVP graph for Acoustic Concepts.
Preparing the CVP Graph In a CVP graph (sometimes called a break-even
chart), unit volume is represented on the horizontal (X) axis and dollars on the vertical
(Y) axis. Preparing a CVP graph involves the three steps depicted in Exhibit 5–1:
1. Draw a line parallel to the volume axis to represent total fixed expense. For Acoustic
Concepts, total fixed expenses are $35,000.
2. Choose some volume of unit sales and plot the point representing total expense (fixed
and variable) at the sales volume you have selected. In Exhibit 5–1, Bob Luchinni
chose a volume of 600 speakers. Total expense at that sales volume is:
Fixed expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expense (600 speakers 3 $150 per speaker) . . . . . . . . .
Total expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 35,000
90,000
$125,000
After the point has been plotted, draw a line through it back to the point where the
fixed expense line intersects the dollars axis.
3. Again choose some sales volume and plot the point representing total sales dollars
at the activity level you have selected. In Exhibit 5–1, Bob Luchinni again chose a
volume of 600 speakers. Sales at that volume total $150,000 (600 speakers 3 $250
per speaker). Draw a line through this point back to the origin.
The interpretation of the completed CVP graph is given in Exhibit 5–2. The anticipated profit or loss at any given level of sales is measured by the vertical distance
between the total revenue line (sales) and the total expense line (variable expense plus
fixed expense).
Cost-Volume-Profit Relationships
EXHIBIT 5–1
Preparing the CVP Graph
$175,000
Step 3
(total sales revenue)
$150,000
$125,000
193
Step 2
(total expense)
$100,000
$75,000
Step 1
(fixed expense)
$50,000
$25,000
$0
0
100
200 300 400 500 600
Volume in speakers sold
700
800
EXHIBIT 5–2
The Completed CVP Graph
$175,000
Total
revenue
$150,000
$125,000
Break-even point:
350 speakers or
$87,500 in sales
$100,000
Total
expense
$75,000
$50,000
Variable expense at
$150 per speaker
Profit
area
Total fixed
expense,
$35,000
Loss
area
$25,000
$0
0
100
200
300
400
500
Volume in speakers sold
600
700
The break-even point is where the total revenue and total expense lines cross. The
break-even point of 350 speakers in Exhibit 5–2 agrees with the break-even point computed earlier.
As discussed earlier, when sales are below the break-even point—in this case, 350
units—the company suffers a loss. Note that the loss (represented by the vertical distance
194
Chapter 5
EXHIBIT 5–3
The Profit Graph
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
Break-even point:
350 speakers
Profit
$5,000
$0
–$5,000
–$10,000
–$15,000
–$20,000
–$25,000
–$30,000
–$35,000
–$40,000
0
100
200
300
400
500
600
700
800
Volume in speakers sold
between the total expense and total revenue lines) gets bigger as sales decline. When
sales are above the break-even point, the company earns a profit and the size of the profit
(represented by the vertical distance between the total revenue and total expense lines)
increases as sales increase.
An even simpler form of the CVP graph, which we call a profit graph, is presented in
Exhibit 5–3. That graph is based on the following equation:
Profit 5 Unit CM 3 Q 2 Fixed expenses
In the case of Acoustic Concepts, the equation can be expressed as:
Profit 5 $100 3 Q 2 $35,000
LO5–3
Use the contribution margin
ratio (CM ratio) to compute
changes in contribution margin
and net operating income
resulting from changes in sales
volume.
Because this is a linear equation, it plots as a single straight line. To plot the line, compute the profit at two different sales volumes, plot the points, and then connect them
with a straight line. For example, when the sales volume is zero (i.e., Q 5 0), the
profit is 2 $35,000 (5 $100 3 0 2 $35,000). When Q is 600, the profit is $25,000
(5 $100 3 600 2 $35,000). These two points are plotted in Exhibit 5–3 and a straight
line has been drawn through them.
The break-even point on the profit graph is the volume of sales at which profit is zero
and is indicated by the dashed line on the graph. Note that the profit steadily increases to
the right of the break-even point as the sales volume increases and that the loss becomes
steadily worse to the left of the break-even point as the sales volume decreases.
Contribution Margin Ratio (CM Ratio)
In the previous section, we explored how cost-volume-profit relationships can be visualized. In this section, we show how the contribution margin ratio can be used in costvolume-profit calculations. As the first step, we have added a column to Acoustic Concepts’
Cost-Volume-Profit Relationships
contribution format income statement in which sales revenues, variable expenses, and
contribution margin are expressed as a percentage of sales:
Total
Per Unit
Percent
of Sales
Sales (400 speakers) . . . . . . . . .
Variable expenses . . . . . . . . . . .
Contribution margin . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . .
$100,000
60,000
40,000
35,000
$250
150
$100
100%
60%
40%
Net operating income . . . . . . . . .
$
5,000
The contribution margin as a percentage of sales is referred to as the contribution
margin ratio (CM ratio). This ratio is computed as follows:
Contribution margin
CM ratio 5 _________________
Sales
For Acoustic Concepts, the computations are:
Total contribution margin
$40,000
CM ratio 5 _____________________ 5 ________ 5 40%
Total sales
$100,000
In a company such as Acoustic Concepts that has only one product, the CM ratio can also
be computed on a per unit basis as follows:
Unit contribution margin $100
CM ratio 5 _____________________ 5 _____ 5 40%
Unit selling price
$250
The CM ratio shows how the contribution margin will be affected by a change in
total sales. Acoustic Concepts’ CM ratio of 40% means that for each dollar increase in
sales, total contribution margin will increase by 40 cents ($1 sales 3 CM ratio of 40%).
Net operating income will also increase by 40 cents, assuming that fixed costs are not
affected by the increase in sales. Generally, the effect of a change in sales on the contribution margin is expressed in equation form as:
Change in contribution margin 5 CM ratio 3 Change in sales
As this illustration suggests, the impact on net operating income of any given dollar
change in total sales can be computed by applying the CM ratio to the dollar change.
For example, if Acoustic Concepts plans a $30,000 increase in sales during the coming month, the contribution margin should increase by $12,000 ($30,000 increase in
sales 3 CM ratio of 40%). As we noted above, net operating income will also increase by
$12,000 if fixed costs do not change. This is verified by the following table:
Sales Volume
Sales . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . .
Present
Expected
Increase
$100,000
60,000
40,000
35,000
$ 5,000
$130,000
78,000*
52,000
35,000
$ 17,000
$30,000
18,000
12,000
0
$12,000
Percent
of Sales
100%
60%
40%
*$130,000 expected sales 4 $250 per unit 5 520 units. 520 units 3 $150 per unit 5 $78,000.
195
196
Chapter 5
The relation between profit and the CM ratio can also be expressed using the following equations:
Profit 5 CM ratio 3 Sales 2 Fixed expenses2
or, in terms of changes,
Change in profit 5 CM ratio 3 Change in sales 2 Change in fixed expenses
For example, at sales of $130,000, the profit is expected to be $17,000 as shown below:
Profit 5 CM ratio 3 Sales 2 Fixed expenses
5 0.40 3 $130,000 2 $35,000
5 $52,000 2 $35,000 5 $17,000
Again, if you are comfortable with algebra, this approach will often be quicker and easier
than constructing contribution format income statements.
The CM ratio is particularly valuable in situations where the dollar sales of one product
must be traded off against the dollar sales of another product. In this situation, products that
yield the greatest amount of contribution margin per dollar of sales should be emphasized.
LO5–4
Some Applications of CVP Concepts
Show the effects on net
operating income of changes
in variable costs, fixed costs,
selling price, and volume.
Bob Luchinni, the accountant at Acoustic Concepts, wanted to demonstrate to the company’s president Prem Narayan how the concepts developed on the preceding pages can
be used in planning and decision making. Bob gathered the following basic data:
Selling price . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . .
Contribution margin . . . . . . . . .
Per Unit
Percent
of Sales
$250
150
$100
100%
60%
40%
Recall that fixed expenses are $35,000 per month. Bob Luchinni will use these data
to show the effects of changes in variable costs, fixed costs, sales price, and sales volume
on the company’s profitability in a variety of situations.
Before proceeding further, however, we need to introduce another concept—the variable expense ratio. The variable expense ratio is the ratio of variable expenses to sales.
It can be computed by dividing the total variable expenses by the total sales, or in a single
product analysis, it can be computed by dividing the variable expenses per unit by the
unit selling price. In the case of Acoustic Concepts, the variable expense ratio is 0.60;
that is, variable expense is 60% of sales. Expressed as an equation, the definition of the
variable expense ratio is:
Variable expenses
Variable expense ratio 5 _______________
Sales
2
This equation can be derived using the basic profit equation and the definition of the CM ratio as
follows:
Profit 5 (Sales 2 Variable expenses) 2 Fixed expenses
Profit 5 Contribution margin 2 Fixed expenses
Contribution margin
Profit 5 _________________ 3 Sales 2 Fixed expenses
Sales
Profit 5 CM ratio 3 Sales 2 Fixed expenses
Cost-Volume-Profit Relationships
This leads to a useful equation that relates the CM ratio to the variable expense ratio
as follows:
Contribution margin
CM ratio 5 _________________
Sales
Sales 2 Variable expenses
CM ratio 5 ______________________
Sales
CM ratio 5 1 2 Variable expense ratio
Change in Fixed Cost and Sales Volume Acoustic Concepts is currently
selling 400 speakers per month at $250 per speaker for total monthly sales of $100,000.
The sales manager feels that a $10,000 increase in the monthly advertising budget would
increase monthly sales by $30,000 to a total of 520 units. Should the advertising budget
be increased? The table below shows the financial impact of the proposed change in the
monthly advertising budget.
Sales . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . .
Contribution margin . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . .
Net operating income . . . . . . . . . .
Current
Sales
Sales with
Additional
Advertising
Budget
Difference
$100,000
60,000
40,000
35,000
$ 5,000
$130,000
78,000*
52,000
45,000†
$ 7,000
$30,000
18,000
12,000
10,000
$ 2,000
Percent
of Sales
100%
60%
40%
*520 units 3 $150 per unit 5 $78,000.
†
$35,000 1 additional $10,000 monthly advertising budget 5 $45,000.
Assuming no other factors need to be considered, the increase in the advertising budget should be approved because it would increase net operating income by $2,000. There
are two shorter ways to arrive at this solution. The first alternative solution follows:
Alternative Solution 1
Expected total contribution margin:
$130,000 3 40% CM ratio . . . . . . . . . . . . . . . .
Present total contribution margin:
$100,000 3 40% CM ratio . . . . . . . . . . . . . . . .
Increase in total contribution margin . . . . . . . . . . .
Change in fixed expenses:
Less incremental advertising expense . . . . . . . .
Increased net operating income . . . . . . . . . . . . . . .
$52,000
40,000
12,000
10,000
$ 2,000
Because in this case only the fixed costs and the sales volume change, the solution
can also be quickly derived as follows:
Alternative Solution 2
Incremental contribution margin:
$30,000 3 40% CM ratio . . . . . . . . . . . . . . . . .
Less incremental advertising expense . . . . . . . . . .
Increased net operating income . . . . . . . . . . . . . . .
$12,000
10,000
$ 2,000
197
198
Chapter 5
Notice that this approach does not depend on knowledge of previous sales. Also note
that it is unnecessary under either shorter approach to prepare an income statement. Both
of the alternative solutions involve incremental analysis—they consider only the costs
and revenues that will change if the new program is implemented. Although in each case
a new income statement could have been prepared, the incremental approach is simpler
and more direct and focuses attention on the specific changes that would occur as a result
of the decision.
Change in Variable Costs and Sales Volume Refer to the original data.
Recall that Acoustic Concepts is currently selling 400 speakers per month. Prem is considering the use of higher-quality components, which would increase variable costs (and
thereby reduce the contribution margin) by $10 per speaker. However, the sales manager
predicts that using higher-quality components would increase sales to 480 speakers per
month. Should the higher-quality components be used?
The $10 increase in variable costs would decrease the unit contribution margin by
$10—from $100 down to $90.
Solution
Expected total contribution margin with higher-quality components:
480 speakers 3 $90 per speaker . . . . . . . . . . . . . . . .
$43,200
Present total contribution margin:
400 speakers 3 $100 per speaker . . . . . . . . . . . . . . .
40,000
$ 3,200
Increase in total contribution margin . . . . . . . . . . . . . . . .
According to this analysis, the higher-quality components should be used. Because
fixed costs would not change, the $3,200 increase in contribution margin shown above
should result in a $3,200 increase in net operating income.
Change in Fixed Cost, Selling Price, and Sales Volume Refer to the
original data and recall again that Acoustic Concepts is currently selling 400 speakers per
month. To increase sales, the sales manager would like to cut the selling price by $20 per
speaker and increase the advertising budget by $15,000 per month. The sales manager
believes that if these two steps are taken, unit sales will increase by 50% to 600 speakers
per month. Should the changes be made?
A decrease in the selling price of $20 per speaker would decrease the unit contribution margin by $20 down to $80.
Solution
Expected total contribution margin with lower selling price:
600 speakers 3 $80 per speaker . . . . . . . . . . . . . . . .
Present total contribution margin:
400 speakers 3 $100 per speaker . . . . . . . . . . . . . . .
Incremental contribution margin . . . . . . . . . . . . . . . . . . . .
Change in fixed expenses:
Less incremental advertising expense . . . . . . . . . . . . .
Reduction in net operating income . . . . . . . . . . . . . . . . .
$48,000
40,000
8,000
15,000
$ (7,000)
According to this analysis, the changes should not be made. The $7,000 reduction
in net operating income that is shown above can be verified by preparing comparative
income statements as shown on the next page.
Cost-Volume-Profit Relationships
Present 400
Speakers
per Month
Sales . . . . . . . . . . . . . . . .
Variable expenses . . . . . .
Contribution margin . . . . .
Fixed expenses . . . . . . . .
Net operating income (loss)
Expected 600
Speakers
per Month
Total
Per Unit
Total
$100,000
60,000
40,000
35,000
$ 5,000
$250
150
$100
$138,000
90,000
48,000
50,000*
$ (2,000)
Per Unit Difference
$230
150
$ 80
$38,000
30,000
8,000
15,000
$ (7,000)
*35,000 1 Additional monthly advertising budget of $15,000 5 $50,000.
Change in Variable Cost, Fixed Cost, and Sales Volume Refer to
Acoustic Concepts’ original data. As before, the company is currently selling 400 speakers per month. The sales manager would like to pay salespersons a sales commission of
$15 per speaker sold, rather than the flat salaries that now total $6,000 per month. The
sales manager is confident that the change would increase monthly sales by 15% to 460
speakers per month. Should the change be made?
Solution Changing the sales staff’s compensation from salaries to commissions
would affect both fixed and variable expenses. Fixed expenses would decrease by $6,000,
from $35,000 to $29,000. Variable expenses per unit would increase by $15, from $150 to
$165, and the unit contribution margin would decrease from $100 to $85.
Expected total contribution margin with sales staff on commissions:
460 speakers 3 $85 per speaker . . . . . . . . . . . . . . . .
$39,100
Present total contribution margin:
400 speakers 3 $100 per speaker . . . . . . . . . . . . . . .
40,000
Decrease in total contribution margin . . . . . . . . . . . . . . .
(900)
Change in fixed expenses:
Add salaries avoided if a commission is paid . . . . . . .
6,000
$ 5,100
Increase in net operating income . . . . . . . . . . . . . . . . . .
According to this analysis, the changes should be made. Again, the same answer can
be obtained by preparing comparative income statements:
Present 400
Speakers
per Month
Sales . . . . . . . . . . . . . . . .
Variable expenses . . . . . .
Contribution margin . . . . .
Fixed expenses . . . . . . . .
Net operating income . . . .
Expected 460
Speakers
per Month
Total
Per Unit
Total
$100,000
60,000
40,000
35,000
$ 5,000
$250
150
$100
$115,000
75,900
39,100
29,000
$ 10,100
Per Unit Difference
$250
165
$ 85
$15,000
15,900
900
(6,000)*
$ 5,100
*Note: A reduction in fixed expenses has the effect of increasing net operating income.
199
200
Chapter 5
Change in Selling Price Refer to the original data where Acoustic Concepts is
currently selling 400 speakers per month. The company has an opportunity to make a
bulk sale of 150 speakers to a wholesaler if an acceptable price can be negotiated. This
sale would not disturb the company’s regular sales and would not affect the company’s
total fixed expenses. What price per speaker should be quoted to the wholesaler if Acoustic Concepts is seeking a profit of $3,000 on the bulk sale?
Solution
Variable cost per speaker . . . . . .
Desired profit per speaker:
$3,000 4 150 speakers . . . . .
Quoted price per speaker . . . . .
$150
20
$170
Notice that fixed expenses are not included in the computation. This is because fixed
expenses are not affected by the bulk sale, so all of the additional contribution margin
increases the company’s profits.
IN BUSINESS
MANAGING RISK IN THE BOOK PUBLISHING INDUSTRY
Greenleaf Book Group is a book publishing company in Austin, Texas, that attracts authors
who are willing to pay publishing costs and forgo up-front advances in exchange for a larger
royalty rate on each book sold. For example, assume a typical publisher prints 10,000 copies of a new book that it sells for $12.50 per unit. The publisher pays the author an advance
of $20,000 to write the book and then incurs $60,000 of expenses to market, print, and edit
the book. The publisher also pays the author a 20% royalty (or $2.50 per unit) on each book
sold above 8,000 units. In this scenario, the publisher must sell 6,400 books to break even
(5 $80,000 in fixed costs 4 $12.50 per unit). If all 10,000 copies are sold, the author earns
$25,000 (5 $20,000 advance 1 2,000 copies 3 $2.50) and the publisher earns $40,000
(5 $125,000 2 $60,000 2 $20,000 2 $5,000).
Greenleaf alters the financial arrangement described above by requiring the author to assume
the risk of poor sales. It pays the author a 70% royalty on all units sold (or $8.75 per unit),
but the author forgoes the $20,000 advance and pays Greenleaf $60,000 to market, print, and
edit the book. If the book flops, the author fails to recover her production costs. If all 10,000 units
are sold, the author earns $27,500 (5 $10,000 units 3 $8.75 2 $60,000) and Greenleaf earns
$37,500 (5 10,000 units 3 ($12.50 2 $8.75)).
Source: Christopher Steiner, “Book It,” Forbes, September 7, 2009, p. 58.
Break-Even and Target Profit Analysis
Managers use break-even and target profit analysis to answer questions such as how
much would we have to sell to avoid incurring a loss or how much would we have to sell
to make a profit of $10,000 per month? We’ll discuss break-even analysis first followed
by target profit analysis.
Break-Even Analysis
LO5–5
Determine the break-even point.
Earlier in the chapter we defined the break-even point as the level of sales at which the
company’s profit is zero. To calculate the break-even point (in unit sales and dollar sales),
managers can use either of two approaches, the equation method or the formula method.
We’ll demonstrate both approaches using the data from Acoustic Concepts.
Cost-Volume-Profit Relationships
The Equation Method The equation method relies on the basic profit equation
introduced earlier in the chapter. Since Acoustic Concepts has only one product, we’ll
use the contribution margin form of this equation to perform the break-even calculations.
Remembering that Acoustic Concepts’ unit contribution margin is $100, and its fixed
expenses are $35,000, the company’s break-even point is computed as follows:
Profit 5 Unit CM 3 Q 2 Fixed expense
$0 5 $100 3 Q 2 $35,000
$100 3 Q 5 $0 1 $35,000
Q 5 $35,000 4 $100
Q 5 350
Thus, as we determined earlier in the chapter, Acoustic Concepts will break even (or earn
zero profit) at a sales volume of 350 speakers per month.
The Formula Method The formula method is a shortcut version of the equation
method. It centers on the idea discussed earlier in the chapter that each unit sold provides
a certain amount of contribution margin that goes toward covering fixed expenses. In a
single product situation, the formula for computing the unit sales to break even is:
Fixed expenses3
Units sales to break even 5 ______________
Unit CM
In the case of Acoustic Concepts, the unit sales needed to break even is computed as follows:
Fixed expenses
Units sales to break even 5 _____________
Unit CM
$35,000
5 _______
$100
5 350
Notice that 350 units is the same answer that we got when using the equation method. This
will always be the case because the formula method and equation method are mathematically equivalent. The formula method simply skips a few steps in the equation method.
Break-Even in Dollar Sales In addition to finding the break-even point in unit
sales, we can also find the break-even point in dollar sales using three methods. First, we
could solve for the break-even point in unit sales using the equation method or formula
method and then simply multiply the result by the selling price. In the case of Acoustic
Concepts, the break-even point in dollar sales using this approach would be computed as
350 speakers 3 $250 per speaker, or $87,500 in total sales.
Second, we can use the equation method to compute the break-even point in dollar
sales. Remembering that Acoustic Concepts’ contribution margin ratio is 40% and its
fixed expenses are $35,000, the equation method calculates the break-even point in dollar
sales as follows:
Profit 5 CM ratio 3 Sales 2 Fixed expenses
$0 5 0.40 3 Sales 2 $35,000
0.40 3 Sales 5 $0 1 $35,000
Sales 5 $35,000 4 0.40
Sales 5 $87,500
3
This formula can be derived as follows:
Profit 5 Unit CM 3 Q 2 Fixed expenses
$0 5 Unit CM 3 Q 2 Fixed expenses
Unit CM 3 Q 5 $0 1 Fixed expenses
Q 5 Fixed expenses 4 Unit CM
201
202
Chapter 5
Third, we can use the formula method to compute the dollar sales needed to break
even as shown below:
Fixed expenses4
Dollar sales to break even 5 ______________
CM ratio
In the case of Acoustic Concepts, the computations are performed as follows:
Fixed expenses
Dollar sales to break even 5 _____________
CM ratio
$35,000
5 _______
0.40
5 $87,500
Again, you’ll notice that the break-even point in dollar sales ($87,500) is the same
under all three methods. This will always be the case because these methods are mathematically equivalent.
LO5–6
Target Profit Analysis
Determine the level of sales
needed to achieve a desired
target profit.
Target profit analysis is one of the key uses of CVP analysis. In target profit analysis,
we estimate what sales volume is needed to achieve a specific target profit. For example,
suppose Prem Narayan of Acoustic Concepts would like to estimate the sales needed to
attain a target profit of $40,000 per month. To determine the unit sales and dollar sales
needed to achieve a target profit, we can rely on the same two approaches that we have
been discussing thus far, the equation method or the formula method.
The Equation Method To compute the unit sales required to achieve a target
profit of $40,000 per month, Acoustic Concepts can use the same profit equation that was
used for its break-even analysis. Remembering that the company’s contribution margin
per unit is $100 and its total fixed expenses are $35,000, the equation method could be
applied as follows:
Profit 5 Unit CM 3 Q 2 Fixed expense
$40,000 5 $100 3 Q 2 $35,000
$100 3 Q 5 $40,000 1 $35,000
Q 5 $75,000 4 $100
Q 5 750
Thus, the target profit can be achieved by selling 750 speakers per month. Notice that
the only difference between this equation and the equation used for Acoustic Concepts’
break-even calculation is the profit figure. In the break-even scenario, the profit is $0,
whereas in the target profit scenario the profit is $40,000.
4
This formula can be derived as follows:
Profit 5 CM ratio 3 Sales 2 Fixed expenses
$0 5 CM ratio 3 Sales 2 Fixed expenses
CM ratio 3 Sales 5 $0 1 Fixed expenses
Sales 5 Fixed expenses 4 CM ratio
Cost-Volume-Profit Relationships
The Formula Method In general, in a single product situation, we can compute
the sales volume required to attain a specific target profit using the following formula:
Target profit 1 Fixed expenses
Units sales to attain the target profit 5 __________________________
Unit CM
In the case of Acoustic Concepts, the unit sales needed to attain a target profit of
40,000 is computed as follows:
Target profit 1 Fixed expenses
Units sales to attain the target profit 5 _________________________
Unit CM
$40,000 1 $35,000
5 ________________
$100
5 750
Target Profit Analysis in Terms of Dollar Sales When quantifying the
dollar sales needed to attain a target profit we can apply the same three methods that we
used for calculating the dollar sales needed to break even. First, we can solve for the unit
sales needed to attain the target profit using the equation method or formula method and
then simply multiply the result by the selling price. In the case of Acoustic Concepts,
the dollar sales to attain its target profit would be computed as 750 speakers 3 $250 per
speaker, or $187,500 in total sales.
Second, we can use the equation method to compute the dollar sales needed to attain
the target profit. Remembering that Acoustic Concepts’ target profit is $40,000, its contribution margin ratio is 40%, and its fixed expenses are $35,000, the equation method
calculates the answer as follows:
Profit 5 CM ratio 3 Sales 2 Fixed expenses
$40,000 5 0.40 3 Sales 2 $35,000
0.40 3 Sales 5 $40,000 1 $35,000
Sales 5 $75,000 4 0.40
Sales 5 $187,500
Third, we can use the formula method to compute the dollar sales needed to attain the
target profit as shown below:
Target profit 1 Fixed expenses
Dollar sales to attain a target profit 5 __________________________
CM ratio
In the case of Acoustic Concepts, the computations would be:
Target profit 1 Fixed expenses
Dollar sales to attain a target profit 5 __________________________
CM ratio
$40,000 1 $35,000
5 ________________
$0.40
5 $187,500
Again, you’ll notice that the answers are the same regardless of which method we
use. This is because all of the methods discussed are simply different roads to the same
destination.
203
204
IN BUSINESS
Chapter 5
SNAP FITNESS GROWS IN A WEAK ECONOMY
When Bally’s Total Fitness was filing for bankruptcy, Snap Fitness was expanding to more than
900 clubs in the United States with 400,000 members. The secret to Snap Fitness’ success is its
“no frills” approach to exercise. Each club typically has five treadmills, two stationary bikes, five
elliptical machines, and weight equipment while bypassing amenities such as on-site child care,
juice bars, and showers. Each club is usually staffed only 25–40 hours per week and it charges a
membership fee of $35 per month.
To open a new Snap Fitness location, each franchise owner has an initial capital outlay
of $120,000 for various types of equipment and a one-time licensing fee of $15,000. The
franchisee also pays Snap (the parent company) a royalty fee of $400 per month plus $0.50
for each membership. Snap also collects one-time fees of $5 for each new member’s “billing
setup” and $5 for each security card issued. If a new club attracts 275 members, it can break
even in as little as three months. Can you estimate the underlying calculations related to this
break-even point?
Source: Nicole Perlroth, “Survival of the Fittest,” Forbes, January 12, 2009, pp. 54–55.
The Margin of Safety
LO5–7
Compute the margin of safety
and explain its significance.
The margin of safety is the excess of budgeted or actual sales dollars over the break-even
volume of sales dollars. It is the amount by which sales can drop before losses are
incurred. The higher the margin of safety, the lower the risk of not breaking even and
incurring a loss. The formula for the margin of safety is:
Margin of safety in dollars 5 Total budgeted (or actual) sales 2 Break-even sales
The margin of safety can also be expressed in percentage form by dividing the margin of safety in dollars by total dollar sales:
Margin of safety in dollars
Margin of safety percentage 5 __________________________________
Total budgeted (or actual) sales in dollars
The calculation of the margin of safety for Acoustic Concepts is:
Sales (at the current volume of 400 speakers) (a) . . . . . . .
Break-even sales (at 350 speakers) . . . . . . . . . . . . . . . . . .
Margin of safety in dollars (b) . . . . . . . . . . . . . . . . . . . . . . .
$100,000
87,500
$ 12,500
Margin of safety percentage, (b) 4 (a) . . . . . . . . . . . . . . . .
12.5%
This margin of safety means that at the current level of sales and with the company’s current prices and cost structure, a reduction in sales of $12,500, or 12.5%, would result in
just breaking even.
In a single-product company like Acoustic Concepts, the margin of safety can also
be expressed in terms of the number of units sold by dividing the margin of safety in
dollars by the selling price per unit. In this case, the margin of safety is 50 speakers
($12,500 4 $250 per speaker 5 50 speakers).
Cost-Volume-Profit Relationships
COMPUTING MARGIN OF SAFETY FOR A SMALL BUSINESS
205
IN BUSINESS
Sam Calagione owns Dogfish Head Craft Brewery, a microbrewery in Rehobeth Beach, Delaware.
He charges distributors as much as $100 per case for his premium beers such as World Wide
Stout. The high-priced microbrews bring in $800,000 in operating income on revenue of $7 million.
Calagione reports that his raw ingredients and labor costs for one case of World Wide Stout are
$30 and $16, respectively. Bottling and packaging costs are $6 per case. Gas and electric costs
are about $10 per case.
If we assume that World Wide Stout is representative of all Dogfish microbrews, then we can
compute the company’s margin of safety in five steps. First, variable cost as a percentage of sales
is 62% [($30 1 $16 1 $6 1 $10)/$100]. Second, the contribution margin ratio is 38% (1 2 0.62).
Third, Dogfish’s total fixed cost is $1,860,000 [($7,000,000 3 0.38) 2 $800,000]. Fourth, the
break-even point in dollar sales is $4,894,737 ($1,860,000/0.38). Fifth, the margin of safety is
$2,105,263 ($7,000,000 2 $4,894,737).
Source: Patricia Huang, “Château Dogfish,” Forbes, February 28, 2005, pp. 57–59.
Prem Narayan and Bob Luchinni met to discuss the results of Bob’s analysis.
Prem: Bob, everything you have shown me is pretty clear. I can see what impact the
sales manager’s suggestions would have on our profits. Some of those suggestions
are quite good and others are not so good. I am concerned that our margin of safety
is only 50 speakers. What can we do to increase this number?
Bob: Well, we have to increase total sales or decrease the break-even point or both.
Prem: And to decrease the break-even point, we have to either decrease our fixed
expenses or increase our unit contribution margin?
Bob: Exactly.
Prem: And to increase our unit contribution margin, we must either increase our selling
price or decrease the variable cost per unit?
Bob: Correct.
Prem: So what do you suggest?
Bob: Well, the analysis doesn’t tell us which of these to do, but it does indicate we have
a potential problem here.
Prem: If you don’t have any immediate suggestions, I would like to call a general meeting next week to discuss ways we can work on increasing the margin of safety. I
think everyone will be concerned about how vulnerable we are to even small downturns in sales.
MANAGERIAL
ACCOUNTING IN ACTION
THE WRAP-UP
CVP Considerations in Choosing a Cost Structure
Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in trading off between these two types of costs.
For example, fixed investments in automated equipment can reduce variable labor costs.
In this section, we discuss the choice of a cost structure. We also introduce the concept of
operating leverage.
Cost Structure and Profit Stability
Which cost structure is better—high variable costs and low fixed costs, or the opposite?
No single answer to this question is possible; each approach has its advantages. To show
what we mean, refer to the following contribution format income statements for two
206
Chapter 5
blueberry farms. Bogside Farm depends on migrant workers to pick its berries by hand,
whereas Sterling Farm has invested in expensive berry-picking machines. Consequently,
Bogside Farm has higher variable costs, but Sterling Farm has higher fixed costs:
Bogside Farm
Sales . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . .
Contribution margin . . . . . . .
Fixed expenses . . . . . . . . . .
Net operating income . . . . . .
Sterling Farm
Amount
Percent
Amount
Percent
$100,000
60,000
40,000
30,000
$ 10,000
100%
60%
40%
$100,000
30,000
70,000
60,000
$ 10,000
100%
30%
70%
Which farm has the better cost structure? The answer depends on many factors,
including the long-run trend in sales, year-to-year fluctuations in the level of sales, and
the attitude of the owners toward risk. If sales are expected to exceed $100,000 in the
future, then Sterling Farm probably has the better cost structure. The reason is that its CM
ratio is higher, and its profits will therefore increase more rapidly as sales increase. To
illustrate, assume that each farm experiences a 10% increase in sales without any increase
in fixed costs. The new income statements would be as follows:
Bogside Farm
Sales . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . .
Contribution margin . . . . . . .
Fixed expenses . . . . . . . . . .
Net operating income . . . . . .
Sterling Farm
Amount
Percent
Amount
Percent
$110,000
66,000
44,000
30,000
$ 14,000
100%
60%
40%
$110,000
33,000
77,000
60,000
$ 17,000
100%
30%
70%
Sterling Farm has experienced a greater increase in net operating income due to its higher
CM ratio even though the increase in sales was the same for both farms.
What if sales drop below $100,000? What are the farms’ break-even points? What are
their margins of safety? The computations needed to answer these questions are shown
below using the formula method:
Bogside
Farm
Sterling
Farm
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . .
Contribution margin ratio . . . . . . . . . . . . . . . . . . . .
Dollar sales to break even . . . . . . . . . . . . . . . . . . .
$ 30,000
4 0.40
$ 75,000
$ 60,000
4 0.70
$ 85,714
Total current sales (a) . . . . . . . . . . . . . . . . . . . . . . .
Break-even sales . . . . . . . . . . . . . . . . . . . . . . . . . .
Margin of safety in sales dollars (b) . . . . . . . . . . . .
$100,000
75,000
$ 25,000
$100,000
85,714
$ 14,286
Margin of safety percentage (b) 4 (a) . . . . . . . . . . .
25.0%
14.3%
Bogside Farm’s margin of safety is greater and its contribution margin ratio is lower
than Sterling Farm. Therefore, Bogside Farm is less vulnerable to downturns than Sterling
Farm. Due to its lower contribution margin ratio, Bogside Farm will not lose contribution
margin as rapidly as Sterling Farm when sales decline. Thus, Bogside Farm’s profit will
be less volatile. We saw earlier that this is a drawback when sales increase, but it provides
Cost-Volume-Profit Relationships
207
more protection when sales drop. And because its break-even point is lower, Bogside
Farm can suffer a larger sales decline before losses emerge.
To summarize, without knowing the future, it is not obvious which cost structure
is better. Both have advantages and disadvantages. Sterling Farm, with its higher fixed
costs and lower variable costs, will experience wider swings in net operating income as
sales fluctuate, with greater profits in good years and greater losses in bad years. Bogside
Farm, with its lower fixed costs and higher variable costs, will enjoy greater profit stability and will be more protected from losses during bad years, but at the cost of lower net
operating income in good years.
Operating Leverage
A lever is a tool for multiplying force. Using a lever, a massive object can be moved with
only a modest amount of force. In business, operating leverage serves a similar purpose.
Operating leverage is a measure of how sensitive net operating income is to a given
percentage change in dollar sales. Operating leverage acts as a multiplier. If operating
leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income.
Operating leverage can be illustrated by returning to the data for the two blueberry
farms. We previously showed that a 10% increase in sales (from $100,000 to $110,000 in
each farm) results in a 70% increase in the net operating income of Sterling Farm (from
$10,000 to $17,000) and only a 40% increase in the net operating income of Bogside
Farm (from $10,000 to $14,000). Thus, for a 10% increase in sales, Sterling Farm experiences a much greater percentage increase in profits than does Bogside Farm. Therefore,
Sterling Farm has greater operating leverage than Bogside Farm.
The degree of operating leverage at a given level of sales is computed by the following formula:
Contribution margin
Degree of operating leverage 5 __________________
Net operating income
The degree of operating leverage is a measure, at a given level of sales, of how a percentage change in sales volume will affect profits. To illustrate, the degree of operating leverage for the two farms at $100,000 sales would be computed as follows:
$40,000
Bogside Farm: _______ 5 4
$10,000
$70,000
Sterling Farm: _______ 5 7
$10,000
Because the degree of operating leverage for Bogside Farm is 4, the farm’s net operating income grows four times as fast as its sales. In contrast, Sterling Farm’s net operating
income grows seven times as fast as its sales. Thus, if sales increase by 10%, then we can
expect the net operating income of Bogside Farm to increase by four times this amount,
or by 40%, and the net operating income of Sterling Farm to increase by seven times this
amount, or by 70%. In general, this relation between the percentage change in sales and the
percentage change in net operating income is given by the following formula:
Percentage
Percentage change in
Degree of
3
5
net operating income operating leverage change in sales
Bogside Farm: Percentage change in net operating income 5 4 3 10% 5 40%
Sterling Farm: Percentage change in net operating income 5 7 3 10% 5 70%
What is responsible for the higher operating leverage at Sterling Farm? The only
difference between the two farms is their cost structure. If two companies have the same
total revenue and same total expense but different cost structures, then the company with
LO5–8
Compute the degree of
operating leverage at a
particular level of sales and
explain how it can be used
to predict changes in net
operating income.
208
Chapter 5
the higher proportion of fixed costs in its cost structure will have higher operating leverage. Referring back to the original example on page 206, when both farms have sales of
$100,000 and total expenses of $90,000, one-third of Bogside Farm’s costs are fixed but
two-thirds of Sterling Farm’s costs are fixed. As a consequence, Sterling’s degree of operating leverage is higher than Bogside’s.
The degree of operating leverage is not a constant; it is greatest at sales levels near
the break-even point and decreases as sales and profits rise. The following table shows
the degree of operating leverage for Bogside Farm at various sales levels. (Data used earlier for Bogside Farm are shown in color.)
Sales . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . .
Contribution margin (a) . . . . .
Fixed expenses . . . . . . . . . .
Net operating income (b) . . .
$75,000
45,000
30,000
30,000
$
0
Degree of operating
leverage, (a) 4 (b) . . . . . . .
`
$80,000 $100,000 $150,000 $225,000
48,000
60,000
90,000
135,000
32,000
40,000
60,000
90,000
30,000
30,000
30,000
30,000
$ 2,000 $ 10,000 $ 30,000 $ 60,000
16
4
2
1.5
Thus, a 10% increase in sales would increase profits by only 15% (10% 3 1.5) if sales
were previously $225,000, as compared to the 40% increase we computed earlier at the
$100,000 sales level. The degree of operating leverage will continue to decrease the farther the company moves from its break-even point. At the break-even point, the degree
of operating leverage is infinitely large ($30,000 contribution margin 4 $0 net operating
income 5 `).
The degree of operating leverage can be used to quickly estimate what impact various
percentage changes in sales will have on profits, without the necessity of preparing detailed
income statements. As shown by our examples, the effects of operating leverage can be
dramatic. If a company is near its break-even point, then even small percentage increases
in sales can yield large percentage increases in profits. This explains why management will
often work very hard for only a small increase in sales volume. If the degree of operating
leverage is 5, then a 6% increase in sales would translate into a 30% increase in profits.
IN BUSINESS
THE DANGERS OF A HIGH DEGREE OF OPERATING LEVERAGE
In recent years, computer chip manufacturers have poured more than $75 billion into constructing new manufacturing facilities to meet the growing demand for digital devices such as iPhones
and Blackberrys. Because 70% of the costs of running these facilities are fixed, a sharp drop in
customer demand forces these companies to choose between two undesirable options. They can
slash production levels and absorb large amounts of unused capacity costs, or they can continue
producing large volumes of output in spite of shrinking demand, thereby flooding the market with
excess supply and lowering prices. Either choice distresses investors who tend to shy away from
computer chip makers in economic downturns.
Source: Bruce Einhorn, “Chipmakers on the Edge,” BusinessWeek, January 5, 2009, pp. 30–31.
Cost-Volume-Profit Relationships
209
Structuring Sales Commissions
Companies usually compensate salespeople by paying them a commission based on
sales, a salary, or a combination of the two. Commissions based on sales dollars can lead
to lower profits. To illustrate, consider Pipeline Unlimited, a producer of surfing equipment. Salespersons sell the company’s products to retail sporting goods stores throughout
North America and the Pacific Basin. Data for two of the company’s surfboards, the XR7
and Turbo models, appear below:
Model
Selling price . . . . . . . . . . . .
Variable expenses . . . . . . .
Contribution margin . . . . . .
XR7
Turbo
$695
344
$351
$749
410
$339
Which model will salespeople push hardest if they are paid a commission of 10% of sales
revenue? The answer is the Turbo because it has the higher selling price and hence the
larger commission. On the other hand, from the standpoint of the company, profits will
be greater if salespeople steer customers toward the XR7 model because it has the higher
contribution margin.
To eliminate such conflicts, commissions can be based on contribution margin rather
than on selling price. If this is done, the salespersons will want to sell the mix of products
that maximizes contribution margin. Providing that fixed costs are not affected by the
sales mix, maximizing the contribution margin will also maximize the company’s profit.5
In effect, by maximizing their own compensation, salespersons will also maximize the
company’s profit.
Sales Mix
Before concluding our discussion of CVP concepts, we need to consider the impact of
changes in sales mix on a company’s profit.
The Definition of Sales Mix
The term sales mix refers to the relative proportions in which a company’s products are
sold. The idea is to achieve the combination, or mix, that will yield the greatest profits.
Most companies have many products, and often these products are not equally profitable.
Hence, profits will depend to some extent on the company’s sales mix. Profits will be
greater if high-margin rather than low-margin items make up a relatively large proportion
of total sales.
Changes in the sales mix can cause perplexing variations in a company’s profits. A
shift in the sales mix from high-margin items to low-margin items can cause total profits
to decrease even though total sales may increase. Conversely, a shift in the sales mix
from low-margin items to high-margin items can cause the reverse effect—total profits
may increase even though total sales decrease. It is one thing to achieve a particular sales
volume; it is quite another to sell the most profitable mix of products.
5
This also assumes the company has no production constraint. If it does, the sales commissions should
be modified. See the Profitability Appendix at the end of the book.
LO5–9
Compute the break-even point
for a multiproduct company and
explain the effects of shifts in
the sales mix on contribution
margin and the break-even point.
210
IN BUSINESS
Chapter 5
NETBOOK SALES CANNIBALIZE PC SALES
When computer manufacturers introduced the “netbook,” they expected it to serve as a consumer’s
third computer—complementing home and office personal computers (PCs) rather than replacing
them. However, when the economy soured many customers decided to buy lower-priced netbooks
instead of PCs, which in turn adversely affected the financial performance of many companies. For
example, when Microsoft failed to achieve its sales goals, the company partially blamed growing
netbook sales and declining PC sales for its troubles. Microsoft’s Windows operating system for
netbooks sells for $15–$25 per device, which is less than half the cost of the company’s least
expensive Windows operating system for PCs.
Source: Olga Kharif, “Small, Cheap—and Frighteningly Popular,” BusinessWeek, December 8, 2008, p. 64.
Sales Mix and Break-Even Analysis
If a company sells more than one product, break-even analysis is more complex than discussed to this point. The reason is that different products will have different selling prices,
different costs, and different contribution margins. Consequently, the break-even point
depends on the mix in which the various products are sold. To illustrate, consider Virtual
Journeys Unlimited, a small company that sells two DVDs: the Monuments DVD, a tour
of the United States’ most popular National Monuments; and the Parks DVD, which
tours the United States’ National Parks. The company’s September sales, expenses, and
break-even point are shown in Exhibit 5–4.
As shown in the exhibit, the break-even point is $60,000 in sales, which was computed by dividing the company’s fixed expenses of $27,000 by its overall CM ratio
of 45%. However, this is the break-even only if the company’s sales mix does not
change. Currently, the Monuments DVD is responsible for 20% and the Parks DVD
for 80% of the company’s dollar sales. Assuming this sales mix does not change, if
total sales are $60,000, the sales of the Monuments DVD would be $12,000 (20% of
$60,000) and the sales of the Parks DVD would be $48,000 (80% of $60,000). As
shown in Exhibit 5–4, at these levels of sales, the company would indeed break even.
But $60,000 in sales represents the break-even point for the company only if the sales
mix does not change. If the sales mix changes, then the break-even point will also
usually change. This is illustrated by the results for October in which the sales mix
shifted away from the more profitable Parks DVD (which has a 50% CM ratio) toward
the less profitable Monuments CD (which has a 25% CM ratio). These results appear
in Exhibit 5–5.
Although sales have remained unchanged at $100,000, the sales mix is exactly
the reverse of what it was in Exhibit 5–4, with the bulk of the sales now coming from
the less profitable Monuments DVD. Notice that this shift in the sales mix has caused
both the overall CM ratio and total profits to drop sharply from the prior month even
though total sales are the same. The overall CM ratio has dropped from 45% in September to only 30% in October, and net operating income has dropped from $18,000
to only $3,000. In addition, with the drop in the overall CM ratio, the company’s
break-even point is no longer $60,000 in sales. Because the company is now realizing
less average contribution margin per dollar of sales, it takes more sales to cover the
same amount of fixed costs. Thus, the break-even point has increased from $60,000 to
$90,000 in sales per year.
In preparing a break-even analysis, an assumption must be made concerning the
sales mix. Usually the assumption is that it will not change. However, if the sales mix
is expected to change, then this must be explicitly considered in any CVP computations.
Cost-Volume-Profit Relationships
211
EXHIBIT 5–4
Multiproduct Break-Even Analysis
Virtual Journeys Unlimited
Contribution Income Statement
For the Month of September
Monuments DVD
Sales . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . .
Amount
$20,000
15,000
$ 5,000
Percent
100%
75%
25%
Parks DVD
Amount
$80,000
40,000
$40,000
Percent
100%
50%
50%
Fixed expenses . . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . . .
Total
Amount
$100,000
55,000
45,000
Percent
100%
55%
45%
27,000
$ 18,000
Computation of the break-even point:
Fixed expenses
$27,000
5
5 $60,000
Overall CM ratio
0.45
Verification of the break-even point:
Current dollar sales . . . . . . . . . . . . .
Percentage of total dollar sales . . . .
Monuments DVD
$20,000
20%
Parks DVD
$80,000
80%
Total
$100,000
100%
Sales at the break-even point . . . . .
$12,000
$48,000
$60,000
Monuments DVD
Sales . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . . .
Amount
$12,000
9,000
$ 3,000
Percent
100%
75%
25%
Parks DVD
Amount
$48,000
24,000
$24,000
Percent
100%
50%
50%
Total
Amount
$ 60,000
33,000
27,000
27,000
$
0
Percent
100%
55%
45%
EXHIBIT 5–5
Multiproduct Break-Even Analysis: A Shift in Sales Mix (see Exhibit 5–4)
Virtual Journeys Unlimited
Contribution Income Statement
For the Month of October
Monuments DVD
Sales . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . .
Amount
$80,000
60,000
$20,000
Percent
100%
75%
25%
Parks DVD
Amount
$20,000
10,000
$10,000
Fixed expenses . . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . . .
Percent
100%
50%
50%
Total
Amount
$100,000
70,000
30,000
27,000
$ 3,000
Computation of the break-even point:
Fixed expenses $27,000
5
5 $90,000
Overall CM ratio
0.30
Percent
100%
70%
30%
212
Chapter 5
Summary
CVP analysis is based on a simple model of how profits respond to prices, costs, and volume. This
model can be used to answer a variety of critical questions such as what is the company’s breakeven volume, what is its margin of safety, and what is likely to happen if specific changes are made
in prices, costs, and volume.
A CVP graph depicts the relationships between unit sales on the one hand and fixed expenses,
variable expenses, total expenses, total sales, and profits on the other hand. The profit graph is
simpler than the CVP graph and shows how profits depend on sales. The CVP and profit graphs are
useful for developing intuition about how costs and profits respond to changes in sales.
The contribution margin ratio is the ratio of the total contribution margin to total sales. This
ratio can be used to quickly estimate what impact a change in total sales would have on net operating income. The ratio is also useful in break-even analysis.
Break-even analysis is used to estimate how much sales would have to be to just break even.
The unit sales required to break even can be estimated by dividing the fixed expense by the unit
contribution margin. Target profit analysis is used to estimate how much sales would have to be to
attain a specified target profit. The unit sales required to attain the target profit can be estimated by
dividing the sum of the target profit and fixed expense by the unit contribution margin.
The margin of safety is the amount by which the company’s current sales exceeds breakeven sales.
The degree of operating leverage allows quick estimation of what impact a given percentage
change in sales would have on the company’s net operating income. The higher the degree of operating leverage, the greater is the impact on the company’s profits. The degree of operating leverage
is not constant—it depends on the company’s current level of sales.
The profits of a multiproduct company are affected by its sales mix. Changes in the sales mix
can affect the break-even point, margin of safety, and other critical factors.
Review Problem: CVP Relationships
Voltar Company manufactures and sells a specialized cordless telephone for high electromagnetic
radiation environments. The company’s contribution format income statement for the most recent
year is given below:
Total
Per Unit
Percent of Sales
Sales (20,000 units) . . . . . . . . . .
Variable expenses . . . . . . . . . . .
$1,200,000
900,000
$60
45
100%
? %
Contribution margin . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . .
300,000
240,000
$15
? %
Net operating income . . . . . . . . .
$
60,000
Management is anxious to increase the company’s profit and has asked for an analysis of a
number of items.
Required:
1.
2.
3.
4.
5.
Compute the company’s CM ratio and variable expense ratio.
Compute the company’s break-even point in both unit sales and dollar sales. Use the equation
method.
Assume that sales increase by $400,000 next year. If cost behavior patterns remain unchanged,
by how much will the company’s net operating income increase? Use the CM ratio to compute
your answer.
Refer to the original data. Assume that next year management wants the company to earn a
profit of at least $90,000. How many units will have to be sold to meet this target profit?
Refer to the original data. Compute the company’s margin of safety in both dollar and percentage form.
Cost-Volume-Profit Relationships
6.
7.
a.
b.
Compute the company’s degree of operating leverage at the present level of sales.
Assume that through a more intense effort by the sales staff, the company’s sales increase
by 8% next year. By what percentage would you expect net operating income to increase?
Use the degree of operating leverage to obtain your answer.
c. Verify your answer to (b) by preparing a new contribution format income statement
showing an 8% increase in sales.
In an effort to increase sales and profits, management is considering the use of a higherquality speaker. The higher-quality speaker would increase variable costs by $3 per unit, but
management could eliminate one quality inspector who is paid a salary of $30,000 per year.
The sales manager estimates that the higher-quality speaker would increase annual sales by at
least 20%.
a. Assuming that changes are made as described above, prepare a projected contribution
format income statement for next year. Show data on a total, per unit, and percentage
basis.
b. Compute the company’s new break-even point in both unit sales and dollar sales. Use the
formula method.
c. Would you recommend that the changes be made?
Solution to Review Problem
1.
Unit contribution margin $15
CM ratio 5 _____________________ 5 ____ 5 25%
$60
Unit selling price
Variable expense $45
Variable expense ratio 5 ______________ 5 ____ 5 75%
Selling price
$60
Profit 5 Unit CM 3 Q 2 Fixed expenses
2.
$0 5 ($60 2 $45) 3 Q 2 $240,000
$15Q 5 $240,000
Q 5 $240,000 4 $15
Q 5 16,000 units; or at $60 per unit, $960,000
3.
4.
Increase in sales . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Multiply by the CM ratio . . . . . . . . . . . . . . . . . . . . . .
Expected increase in contribution margin . . . . . . . .
$400,000
3 25%
$100,000
Because the fixed expenses are not expected to change, net operating income will increase by
the entire $100,000 increase in contribution margin computed above.
Equation method:
Profit 5 Unit CM 3 Q 2 Fixed expenses
$90,000 5 ($60 2 $45) 3 Q 2 $240,000
$15Q 5 $90,000 1 $240,000
Q 5 $330,000 4 $15
Q 5 22,000 units
Formula method:
Target profit 1 Fixed expenses _________________
Unit sales to attain _________________________
$90,000 1 $240,000
5
5 22,000 units
5
the target profit
Contribution margin per unit
$15 per unit
5.
Margin of safety in dollars 5 Total sales 2 Break-even sales
5 $1,200,000 2 $960,000 5 $240,000
Margin of safety in dollars
$240,000
Margin of safety percentage 5 ______________________ 5 __________ 5 20%
$1,200,000
Total sales
213
214
Chapter 5
6.
a.
Contribution margin
$300,000
Degree of operating leverage 5 __________________ 5 ________ 5 5
$60,000
Net operating income
b.
c.
Expected increase in sales . . . . . . . . . . . . . . . . . . . . . . .
Degree of operating leverage . . . . . . . . . . . . . . . . . . . . .
8%
35
Expected increase in net operating income . . . . . . . . . .
40%
If sales increase by 8%, then 21,600 units (20,000 3 1.08 5 21,600) will be sold next
year. The new contribution format income statement would be as follows:
Total
Per Unit
Percent of Sales
Sales (21,600 units) . . . . . . . . . . .
Variable expenses . . . . . . . . . . . .
$1,296,000
972,000
$60
45
100%
75%
Contribution margin . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . .
324,000
240,000
$15
25%
Net operating income . . . . . . . . . .
$
84,000
Thus, the $84,000 expected net operating income for next year represents a 40% increase over the
$60,000 net operating income earned during the current year:
$24,000
$84,000 2 $60,000 _______
________________
5
5 40% increase
$60,000
$60,000
Note that the increase in sales from 20,000 to 21,600 units has increased both total sales and total
variable expenses.
7.
a.
A 20% increase in sales would result in 24,000 units being sold next year: 20,000 units 3
1.20 5 24,000 units.
Sales (24,000 units) . . . . . . . . . .
Variable expenses . . . . . . . . . . .
Total
Per Unit
Percent of Sales
$1,440,000
1,152,000
$60
48*
100%
80%
$12
20%
Contribution margin . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . .
Net operating income . . . . . . . . .
288,000
210,000†
$
78,000
*$45 1 $3 5 $48; $48 4 $60 5 80%.
†
$240,000 2 $30,000 5 $210,000.
Note that the change in per unit variable expenses results in a change in both the per unit contribution margin and the CM ratio.
Fixed expenses
b.
Unit sales to break even 5 _____________________
Unit contribution margin
$210,000
5 __________ 5 17,500 units
$12 per unit
Fixed expenses
Dollar sales to break even 5 _____________
CM ratio
$210,000
5 ________ 5 $1,050,000
0.20
c.
Yes, based on these data, the changes should be made. The changes increase the company’s net operating income from the present $60,000 to $78,000 per year. Although the
changes also result in a higher break-even point (17,500 units as compared to the present
16,000 units), the company’s margin of safety actually becomes greater than before:
Margin of safety in dollars 5 Total sales 2 Break-even sales
5 $1,440,000 2 $1,050,000 5 $390,000
As shown in (5) on the prior page, the company’s present margin of safety is only $240,000. Thus,
several benefits will result from the proposed changes.
Cost-Volume-Profit Relationships
215
Glossary
Break-even point The level of sales at which profit is zero. (p. 190)
Contribution margin ratio (CM ratio) A ratio computed by dividing contribution margin by
dollar sales. (p. 195)
Cost-volume-profit (CVP) graph A graphical representation of the relationships between an
organization’s revenues, costs, and profits on the one hand and its sales volume on the other
hand. (p. 192)
Degree of operating leverage A measure, at a given level of sales, of how a percentage change in
sales will affect profits. The degree of operating leverage is computed by dividing contribution margin by net operating income. (p. 207)
Incremental analysis An analytical approach that focuses only on those costs and revenues that
change as a result of a decision. (p. 198)
Margin of safety The excess of budgeted or actual dollar sales over the break-even dollar sales.
(p. 204)
Operating leverage A measure of how sensitive net operating income is to a given percentage
change in dollar sales. (p. 207)
Sales mix The relative proportions in which a company’s products are sold. Sales mix is computed by expressing the sales of each product as a percentage of total sales. (p. 209)
Target profit analysis Estimating what sales volume is needed to achieve a specific target profit.
(p. 202)
Variable expense ratio A ratio computed by dividing variable expenses by dollar sales. (p. 196)
Questions
5–1
5–2
5–3
5–4
5–5
5–6
5–7
5–8
5–9
What is meant by a product’s contribution margin ratio? How is this ratio useful in planning business operations?
Often the most direct route to a business decision is an incremental analysis. What is
meant by an incremental analysis?
In all respects, Company A and Company B are identical except that Company A’s costs
are mostly variable, whereas Company B’s costs are mostly fixed. When sales increase,
which company will tend to realize the greatest increase in profits? Explain.
What is meant by the term operating leverage?
What is meant by the term break-even point?
In response to a request from your immediate supervisor, you have prepared a CVP
graph portraying the cost and revenue characteristics of your company’s product and
operations. Explain how the lines on the graph and the break-even point would change
if (a) the selling price per unit decreased, (b) fixed cost increased throughout the entire
range of activity portrayed on the graph, and (c) variable cost per unit increased.
What is meant by the margin of safety?
What is meant by the term sales mix? What assumption is usually made concerning sales
mix in CVP analysis?
Explain how a shift in the sales mix could result in both a higher break-even point and a
lower net income.
Multiple-choice questions are provided on the text website at www.mhhe.com/garrison15e.
Applying Excel
Available with McGraw-Hill’s Connect® Accounting.
The Excel worksheet form that appears on the next page is to be used to recreate portions of the
Review Problem on pages 212–214. Download the workbook containing this form from the Online
Learning Center at www.mhhe.com/garrison15e. On the website you will also receive instructions about how to use this worksheet form.
LO5–6, LO5–7, LO5–8
216
Chapter 5
You should proceed to the requirements below only after completing your worksheet.
Required:
1.
2.
Check your worksheet by changing the fixed expenses to $270,000. If your worksheet is operating properly, the degree of operating leverage should be 10. If you do not get this answer,
find the errors in your worksheet and correct them. How much is the margin of safety percentage? Did it change? Why or why not?
Enter the following data from a different company into your worksheet:
Unit sales . . . . . . . . . . . . . . . . . . .
Selling price per unit . . . . . . . . . . .
Variable expenses per unit . . . . . .
Fixed expenses . . . . . . . . . . . . . .
3.
4.
10,000 units
$120 per unit
$72 per unit
$420,000
What is the margin of safety percentage? What is the degree of operating leverage?
Using the degree of operating leverage and without changing anything in your worksheet,
calculate the percentage change in net operating income if unit sales increase by 15%.
Confirm the calculations you made in part (3) above by increasing the unit sales in your worksheet by 15%. What is the new net operating income and by what percentage did it increase?
Cost-Volume-Profit Relationships
5.
217
Thad Morgan, a motorcycle enthusiast, has been exploring the possibility of relaunching the
Western Hombre brand of cycle that was popular in the 1930s. The retro-look cycle would be
sold for $10,000 and at that price, Thad estimates 600 units would be sold each year. The variable cost to produce and sell the cycles would be $7,500 per unit. The annual fixed cost would
be $1,200,000.
a. Using your worksheet, what would be the break-even unit sales, the margin of safety in
dollars, and the degree of operating leverage?
b. Thad is worried about the selling price. Rumors are circulating that other retro brands
of cycles may be revived. If so, the selling price for the Western Hombre would have
to be reduced to $9,000 to compete effectively. In that event, Thad would also reduce
fixed expenses by $300,000 by reducing advertising expenses, but he still hopes to sell
600 units per year. Do you think this is a good plan? Explain. Also, explain the degree of
operating leverage that appears on your worksheet.
The Foundational 15
Available with McGraw-Hill’s Connect® Accounting.
Oslo Company prepared the following contribution format income statement based on a sales
volume of 1,000 units (the relevant range of production is 500 units to 1,500 units):
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . .
$20,000
12,000
Contribution margin . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . .
8,000
6,000
Net operating income . . . . . . . . . . . . . . . . . .
$ 2,000
Required:
(Answer each question independently and always refer to the original data unless instructed
otherwise.)
1. What is the contribution margin per unit?
2. What is the contribution margin ratio?
3. What is the variable expense ratio?
4. If sales increase to 1,001 units, what would be the increase in net operating income?
5. If sales decline to 900 units, what would be the net operating income?
6. If the selling price increases by $2 per unit and the sales volume decreases by 100 units, what
would be the net operating income?
7. If the variable cost per unit increases by $1, spending on advertising increases by $1,500,
and unit sales increase by 250 units, what would be the net operating income?
8. What is the break-even point in unit sales?
9. What is the break-even point in dollar sales?
10. How many units must be sold to achieve a target profit of $5,000?
11. What is the margin of safety in dollars? What is the margin of safety percentage?
12. What is the degree of operating leverage?
13. Using the degree of operating leverage, what is the estimated percent increase in net operating income of a 5% increase in sales?
14. Assume that the amounts of the company’s total variable expenses and total fixed expenses
were reversed. In other words, assume that the total variable expenses are $6,000 and the
total fixed expenses are $12,000. Under this scenario and assuming that total sales remain
the same, what is the degree of operating leverage?
15. Using the degree of operating leverage that you computed in the previous question, what is
the estimated percent increase in net operating income of a 5% increase in sales?
LO5–1, LO5–3, LO5–4,
LO5–5, LO5–6, LO5–7,
LO5–8
218
Chapter 5
Exercises
All applicable exercises are available with McGraw-Hill’s Connect® Accounting.
EXERCISE 5–1 Preparing a Contribution Format Income Statement [LO5–1]
Whirly Corporation’s most recent income statement is shown below:
Total
Per Unit
Sales (10,000 units) . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . .
$350,000
200,000
$35.00
20.00
Contribution margin . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . .
150,000
135,000
$15.00
Net operating income . . . . . . . . . . . . .
$ 15,000
Required:
Prepare a new contribution format income statement under each of the following conditions (consider each case independently):
1. The sales volume increases by 100 units.
2. The sales volume decreases by 100 units.
3. The sales volume is 9,000 units.
EXERCISE 5–2 Prepare a Cost-Volume-Profit (CVP) Graph [LO5–2]
Karlik Enterprises distributes a single product whose selling price is $24 and whose variable
expense is $18 per unit. The company’s monthly fixed expense is $24,000.
Required:
1.
2.
Prepare a cost-volume-profit graph for the company up to a sales level of 8,000 units.
Estimate the company’s break-even point in unit sales using your cost-volume-profit graph.
EXERCISE 5–3 Prepare a Profit Graph [LO5–2]
Jaffre Enterprises distributes a single product whose selling price is $16 and whose variable
expense is $11 per unit. The company’s fixed expense is $16,000 per month.
Required:
1.
2.
Prepare a profit graph for the company up to a sales level of 4,000 units.
Estimate the company’s break-even point in unit sales using your profit graph.
EXERCISE 5–4 Computing and Using the CM Ratio [LO5–3]
Last month when Holiday Creations, Inc., sold 50,000 units, total sales were $200,000, total variable expenses were $120,000, and fixed expenses were $65,000.
Required:
1.
2.
What is the company’s contribution margin (CM) ratio?
Estimate the change in the company’s net operating income if it were to increase its total sales
by $1,000.
EXERCISE 5–5 Changes in Variable Costs, Fixed Costs, Selling Price, and Volume [LO5–4]
Data for Hermann Corporation are shown below:
Per Unit
Percent of Sales
Selling price . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . .
$90
63
100%
70
Contribution margin . . . . . . . . .
$27
30%
Fixed expenses are $30,000 per month and the company is selling 2,000 units per month.
Cost-Volume-Profit Relationships
Required:
1.
2.
The marketing manager argues that a $5,000 increase in the monthly advertising budget would
increase monthly sales by $9,000. Should the advertising budget be increased?
Refer to the original data. Management is considering using higher-quality components that
would increase the variable expense by $2 per unit. The marketing manager believes that the
higher-quality product would increase sales by 10% per month. Should the higher-quality
components be used?
EXERCISE 5–6 Compute the Break-Even Point [LO5–5]
Mauro Products distributes a single product, a woven basket whose selling price is $15 and whose
variable expense is $12 per unit. The company’s monthly fixed expense is $4,200.
Required:
1.
2.
3.
4.
Solve for the company’s break-even point in unit sales using the equation method.
Solve for the company’s break-even point in dollar sales using the equation method and the
CM ratio.
Solve for the company’s break-even point in unit sales using the formula method.
Solve for the company’s break-even point in dollar sales using the formula method and the
CM ratio.
EXERCISE 5–7 Compute the Level of Sales Required to Attain a Target Profit [LO5–6]
Lin Corporation has a single product whose selling price is $120 and whose variable expense is
$80 per unit. The company’s monthly fixed expense is $50,000.
Required:
1.
2.
Using the equation method, solve for the unit sales that are required to earn a target profit of
$10,000.
Using the formula method, solve for the unit sales that are required to earn a target profit of
$15,000.
EXERCISE 5–8 Compute the Margin of Safety [LO5–7]
Molander Corporation is a distributor of a sun umbrella used at resort hotels. Data concerning the
next month’s budget appear below:
Selling price . . . . . . . . . . . .
Variable expenses . . . . . . .
Fixed expenses . . . . . . . . .
Unit sales . . . . . . . . . . . . . .
$30 per unit
$20 per unit
$7,500 per month
1,000 units per month
Required:
1.
2.
Compute the company’s margin of safety.
Compute the company’s margin of safety as a percentage of its sales.
EXERCISE 5–9 Compute and Use the Degree of Operating Leverage [LO5–8]
Engberg Company installs lawn sod in home yards. The company’s most recent monthly contribution format income statement follows:
Amount
Percent of Sales
Sales . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . .
$80,000
32,000
100%
40%
Contribution margin . . . . . . . . .
Fixed expenses . . . . . . . . . . . .
48,000
38,000
60%
Net operating income . . . . . . . .
$10,000
Required:
1.
2.
3.
Compute the company’s degree of operating leverage.
Using the degree of operating leverage, estimate the impact on net operating income of a 5%
increase in sales.
Verify your estimate from part (2) above by constructing a new contribution format income
statement for the company assuming a 5% increase in sales.
219
220
Chapter 5
EXERCISE 5–10 Compute the Break-Even Point for a Multiproduct Company [LO5–9]
Lucido Products markets two computer games: Claimjumper and Makeover. A contribution format
income statement for a recent month for the two games appears below:
Claimjumper
Makeover
Total
Sales . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . .
$30,000
20,000
$70,000
50,000
$100,000
70,000
Contribution margin . . . . . . . . .
Fixed expenses . . . . . . . . . . . .
$10,000
$20,000
30,000
24,000
$
Net operating income . . . . . . . .
6,000
Required:
1.
2.
3.
Compute the overall contribution margin (CM) ratio for the company.
Compute the overall break-even point for the company in dollar sales.
Verify the overall break-even point for the company by constructing a contribution format
income statement showing the appropriate levels of sales for the two products.
EXERCISE 5–11 Missing Data; Basic CVP Concepts [LO5–1, LO5–9]
Fill in the missing amounts in each of the eight case situations below. Each case is independent of
the others. (Hint: One way to find the missing amounts would be to prepare a contribution format
income statement for each case, enter the known data, and then compute the missing items.)
a. Assume that only one product is being sold in each of the four following case situations:
Case
1........
2........
3........
4........
b.
Units
Sold
15,000
?
10,000
6,000
Sales
Variable
Expenses
Contribution
Margin
per Unit
Fixed
Expenses
Net Operating
Income
(Loss)
$180,000
$100,000
?
$300,000
$120,000
?
$70,000
?
?
$10
$13
?
$50,000
$32,000
?
$100,000
?
$8,000
$12,000
$(10,000)
Assume that more than one product is being sold in each of the four following case situations:
Case
1................
2................
3................
4................
Sales
Variable
Expenses
Average
Contribution
Margin
Ratio
Fixed
Expenses
Net Operating
Income
(Loss)
$500,000
$400,000
?
$600,000
?
$260,000
?
$420,000
20%
?
60%
?
?
$100,000
$130,000
?
$7,000
?
$20,000
$(5,000)
EXERCISE 5–12 Multiproduct Break-Even Analysis [LO5–9]
Olongapo Sports Corporation distributes two premium golf balls—the Flight Dynamic and the
Sure Shot. Monthly sales and the contribution margin ratios for the two products follow:
Product
Flight Dynamic
Sure Shot
Total
$150,000
80%
$250,000
36%
$400,000
?
Sales . . . . . . . . .
CM ratio . . . . . . .
Fixed expenses total $183,750 per month.
Cost-Volume-Profit Relationships
Required:
1.
2.
3.
Prepare a contribution format income statement for the company as a whole. Carry computations to one decimal place.
Compute the break-even point for the company based on the current sales mix.
If sales increase by $100,000 a month, by how much would you expect net operating income
to increase? What are your assumptions?
EXERCISE 5–13 Using a Contribution Format Income Statement [LO5–1, LO5–4]
Miller Company’s most recent contribution format income statement is shown below:
Total
Per Unit
Sales (20,000 units) . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . .
$300,000
180,000
$15.00
9.00
Contribution margin . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . .
120,000
70,000
$ 6.00
Net operating income . . . . . . . . . . . . .
$ 50,000
Required:
Prepare a new contribution format income statement under each of the following conditions (consider each case independently):
1. The number of units sold increases by 15%.
2. The selling price decreases by $1.50 per unit, and the number of units sold increases by 25%.
3. The selling price increases by $1.50 per unit, fixed expenses increase by $20,000, and the
number of units sold decreases by 5%.
4. The selling price increases by 12%, variable expenses increase by 60 cents per unit, and the
number of units sold decreases by 10%.
EXERCISE 5–14 Break-Even and Target Profit Analysis [LO5–3, LO5–4, LO5–5, LO5–6]
Lindon Company is the exclusive distributor for an automotive product that sells for $40 per unit
and has a CM ratio of 30%. The company’s fixed expenses are $180,000 per year. The company
plans to sell 16,000 units this year.
Required:
1.
2.
3.
What are the variable expenses per unit?
Using the equation method:
a. What is the break-even point in unit sales and in dollar sales?
b. What amount of unit sales and dollar sales is required to earn an annual profit of
$60,000?
c. Assume that by using a more efficient shipper, the company is able to reduce its variable
expenses by $4 per unit. What is the company’s new break-even point in unit sales and in
dollar sales?
Repeat (2) above using the formula method.
EXERCISE 5–15 Operating Leverage [LO5–4, LO5–8]
Magic Realm, Inc., has developed a new fantasy board game. The company sold 15,000 games last
year at a selling price of $20 per game. Fixed expenses associated with the game total $182,000
per year, and variable expenses are $6 per game. Production of the game is entrusted to a printing
contractor. Variable expenses consist mostly of payments to this contractor.
Required:
1.
2.
Prepare a contribution format income statement for the game last year and compute the degree
of operating leverage.
Management is confident that the company can sell 18,000 games next year (an increase of
3,000 games, or 20%, over last year). Compute:
a. The expected percentage increase in net operating income for next year.
b. The expected total dollar net operating income for next year. (Do not prepare an income
statement; use the degree of operating leverage to compute your answer.)
221
222
Chapter 5
EXERCISE 5–16 Break-Even Analysis and CVP Graphing [LO5–2, LO5–4, LO5–5]
The Hartford Symphony Guild is planning its annual dinner-dance. The dinner-dance committee
has assembled the following expected costs for the event:
Dinner (per person) . . . . . . . . . . . . . . . . . . . . . . . . . .
Favors and program (per person) . . . . . . . . . . . . . . .
Band . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Rental of ballroom . . . . . . . . . . . . . . . . . . . . . . . . . .
Professional entertainment during intermission . . . .
Tickets and advertising . . . . . . . . . . . . . . . . . . . . . .
$18
$2
$2,800
$900
$1,000
$1,300
The committee members would like to charge $35 per person for the evening’s activities.
Required:
1.
2.
3.
Compute the break-even point for the dinner-dance (in terms of the number of persons who
must attend).
Assume that last year only 300 persons attended the dinner-dance. If the same number attend
this year, what price per ticket must be charged in order to break even?
Refer to the original data ($35 ticket price per person). Prepare a CVP graph for the dinnerdance from zero tickets up to 600 tickets sold.
EXERCISE 5–17 Break-Even and Target Profit Analysis [LO5–4, LO5–5, LO5–6]
Outback Outfitters sells recreational equipment. One of the company’s products, a small camp
stove, sells for $50 per unit. Variable expenses are $32 per stove, and fixed expenses associated
with the stove total $108,000 per month.
Required:
1.
2.
3.
4.
Compute the break-even point in unit sales and in dollar sales.
If the variable expenses per stove increase as a percentage of the selling price, will it result in a
higher or a lower break-even point? Why? (Assume that the fixed expenses remain unchanged.)
At present, the company is selling 8,000 stoves per month. The sales manager is convinced
that a 10% reduction in the selling price would result in a 25% increase in monthly sales of
stoves. Prepare two contribution format income statements, one under present operating conditions, and one as operations would appear after the proposed changes. Show both total and
per unit data on your statements.
Refer to the data in (3) above. How many stoves would have to be sold at the new selling price
to yield a minimum net operating income of $35,000 per month?
EXERCISE 5–18 Break-Even and Target Profit Analysis; Margin of Safety; CM Ratio [LO5–1, LO5–3,
LO5–5, LO5–6, LO5–7]
Menlo Company distributes a single product. The company’s sales and expenses for last month
follow:
Total
Per Unit
Sales . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . .
$450,000
180,000
$30
12
Contribution margin . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . .
270,000
216,000
$18
Net operating income . . . . . . . . . . . . .
$ 54,000
Required:
1.
2.
3.
4.
5.
What is the monthly break-even point in unit sales and in dollar sales?
Without resorting to computations, what is the total contribution margin at the break-even
point?
How many units would have to be sold each month to earn a target profit of $90,000? Use the
formula method. Verify your answer by preparing a contribution format income statement at
the target sales level.
Refer to the original data. Compute the company’s margin of safety in both dollar and percentage terms.
What is the company’s CM ratio? If sales increase by $50,000 per month and there is no change
in fixed expenses, by how much would you expect monthly net operating income to increase?
Cost-Volume-Profit Relationships
223
Problems
All applicable problems are available with McGraw-Hill’s Connect® Accounting.
PROBLEM 5–19 Break-Even Analysis; Pricing [LO5–1, LO5–4, LO5–5]
Minden Company introduced a new product last year for which it is trying to find an optimal selling price. Marketing studies suggest that the company can increase sales by 5,000 units for each
$2 reduction in the selling price. The company’s present selling price is $70 per unit, and variable
expenses are $40 per unit. Fixed expenses are $540,000 per year. The present annual sales volume
(at the $70 selling price) is 15,000 units.
Required:
1.
2.
3.
4.
What is the present yearly net operating income or loss?
What is the present break-even point in unit sales and in dollar sales?
Assuming that the marketing studies are correct, what is the maximum annual profit that the
company can earn? At how many units and at what selling price per unit would the company
generate this profit?
What would be the break-even point in unit sales and in dollar sales using the selling price you
determined in (3) above (e.g., the selling price at the level of maximum profits)? Why is this
break-even point different from the break-even point you computed in (2) above?
PROBLEM 5–20 Various CVP Questions: Break-Even Point; Cost Structure; Target Sales [LO5–1, LO5–3,
LO5–4, LO5–5, LO5–6, LO5–8]
Northwood Company manufactures basketballs. The company has a ball that sells for $25. At
present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus,
variable expenses are high, totaling $15 per ball, of which 60% is direct labor cost.
Last year, the company sold 30,000 of these balls, with the following results:
Sales (30,000 balls) . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . . .
$750,000
450,000
Contribution margin . . . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . .
300,000
210,000
Net operating income . . . . . . . . . . . . . . . . . . . .
$ 90,000
Required:
1.
2.
3.
4.
5.
6.
Compute (a) the CM ratio and the break-even point in balls, and (b) the degree of operating
leverage at last year’s sales level.
Due to an increase in labor rates, the company estimates that variable expenses will increase
by $3 per ball next year. If this change takes place and the selling price per ball remains constant at $25, what will be the new CM ratio and break-even point in balls?
Refer to the data in (2) above. If the expected change in variable expenses takes place, how
many balls will have to be sold next year to earn the same net operating income, $90,000, as
last year?
Refer again to the data in (2) above. The president feels that the company must raise the selling price of its basketballs. If Northwood Company wants to maintain the same CM ratio
as last year, what selling price per ball must it charge next year to cover the increased labor
costs?
Refer to the original data. The company is discussing the construction of a new, automated
manufacturing plant. The new plant would slash variable expenses per ball by 40%, but it
would cause fixed expenses per year to double. If the new plant is built, what would be the
company’s new CM ratio and new break-even point in balls?
Refer to the data in (5) above.
a. If the new plant is built, how many balls will have to be sold next year to earn the same
net operating income, $90,000, as last year?
b. Assume the new plant is built and that next year the company manufactures and sells
30,000 balls (the same number as sold last year). Prepare a contribution format income
statement and compute the degree of operating leverage.
c. If you were a member of top management, would you have been in favor of constructing
the new plant? Explain.
224
Chapter 5
PROBLEM 5–21 Sales Mix; Multiproduct Break-Even Analysis [LO5–9]
Gold Star Rice, Ltd., of Thailand exports Thai rice throughout Asia. The company grows three
varieties of rice—Fragrant, White, and Loonzain. Budgeted sales by product and in total for the
coming month are shown below:
Product
White
Fragrant
Loonzain
Total
Percentage of total sales
Sales . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . .
20%
$150,000
108,000
100%
72%
52%
$390,000
78,000
100%
20%
28%
$210,000
84,000
100%
40%
100%
$750,000
270,000
100%
36%
Contribution margin . . . . . . . . . .
$ 42,000
28%
$312,000
80%
$126,000
60%
480,000
64%
Fixed expenses . . . . . . . . . . . . .
449,280
Net operating income . . . . . . . . .
$30,720
Fixed expenses ________
$449,280
Dollar sales to 5 _____________
5
5 $702,000
break even
CM ratio
0.64
As shown by these data, net operating income is budgeted at $30,720 for the month and breakeven sales at $702,000.
Assume that actual sales for the month total $750,000 as planned. Actual sales by product are:
White, $300,000; Fragrant, $180,000; and Loonzain, $270,000.
Required:
1.
2.
3.
Prepare a contribution format income statement for the month based on actual sales data.
Present the income statement in the format shown above.
Compute the break-even point in dollar sales for the month based on your actual data.
Considering the fact that the company met its $750,000 sales budget for the month, the president is shocked at the results shown on your income statement in (1) above. Prepare a brief
memo for the president explaining why both the operating results and the break-even point in
dollar sales are different from what was budgeted.
PROBLEM 5–22 Basics of CVP Analysis; Cost Structure [LO5–1, LO5–3, LO5–4, LO5–5, LO5–6]
Due to erratic sales of its sole product—a high-capacity battery for laptop computers—PEM, Inc.,
has been experiencing difficulty for some time. The company’s contribution format income statement for the most recent month is given below:
Sales (19,500 units 3 $30 per unit) . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . . .
$585,000
409,500
Contribution margin . . . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . .
175,500
180,000
Net operating loss . . . . . . . . . . . . . . . . . . . . . .
$ (4,500)
Required:
1.
2.
3.
4.
Compute the company’s CM ratio and its break-even point in both unit sales and dollar sales.
The president believes that a $16,000 increase in the monthly advertising budget, combined
with an intensified effort by the sales staff, will result in an $80,000 increase in monthly
sales. If the president is right, what will be the effect on the company’s monthly net operating
income or loss? (Use the incremental approach in preparing your answer.)
Refer to the original data. The sales manager is convinced that a 10% reduction in the selling
price, combined with an increase of $60,000 in the monthly advertising budget, will double
unit sales. What will the new contribution format income statement look like if these changes
are adopted?
Refer to the original data. The Marketing Department thinks that a fancy new package for the
laptop computer battery would help sales. The new package would increase packaging costs
by 75 cents per unit. Assuming no other changes, how many units would have to be sold each
month to earn a profit of $9,750?
Cost-Volume-Profit Relationships
5.
Refer to the original data. By automating, the company could reduce variable expenses by $3 per
unit. However, fixed expenses would increase by $72,000 each month.
a. Compute the new CM ratio and the new break-even point in both unit sales and dollar sales.
b. Assume that the company expects to sell 26,000 units next month. Prepare two contribution format income statements, one assuming that operations are not automated and one
assuming that they are. (Show data on a per unit and percentage basis, as well as in total,
for each alternative.)
c. Would you recommend that the company automate its operations? Explain.
PROBLEM 5–23 Basics of CVP Analysis [LO5–1, LO5–3, LO5–4, LO5–5, LO5–8]
Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $20 per unit. Variable expenses are $8 per unit, and fixed expenses total $180,000 per year.
Required:
Answer the following independent questions:
1. What is the product’s CM ratio?
2. Use the CM ratio to determine the break-even point in dollar sales.
3. Due to an increase in demand, the company estimates that sales will increase by $75,000 during the next year. By how much should net operating income increase (or net loss decrease)
assuming that fixed expenses do not change?
4. Assume that the operating results for last year were:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . . .
$400,000
160,000
Contribution margin . . . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . .
240,000
180,000
Net operating income . . . . . . . . . . . . . . . . . . . .
$ 60,000
a.
b.
5.
6.
Compute the degree of operating leverage at the current level of sales.
The president expects sales to increase by 20% next year. By what percentage should net
operating income increase?
Refer to the original data. Assume that the company sold 18,000 units last year. The sales
manager is convinced that a 10% reduction in the selling price, combined with a $30,000
increase in advertising, would increase annual unit sales by one-third. Prepare two contribution format income statements, one showing the results of last year’s operations and one
showing the results of operations if these changes are made. Would you recommend that the
company do as the sales manager suggests?
Refer to the original data. Assume again that the company sold 18,000 units last year. The president does not want to change the selling price. Instead, he wants to increase the sales commission by $1 per unit. He thinks that this move, combined with some increase in advertising, would
increase annual sales by 25%. By how much could advertising be increased with profits remaining
unchanged? Do not prepare an income statement; use the incremental analysis approach.
PROBLEM 5–24 Break-Even and Target Profit Analysis [LO5–5, LO5–6]
The Shirt Works sells a large variety of tee shirts and sweatshirts. Steve Hooper, the owner, is
thinking of expanding his sales by hiring high school students, on a commission basis, to sell
sweatshirts bearing the name and mascot of the local high school.
These sweatshirts would have to be ordered from the manufacturer six weeks in advance, and
they could not be returned because of the unique printing required. The sweatshirts would cost
Hooper $8 each with a minimum order of 75 sweatshirts. Any additional sweatshirts would have to
be ordered in increments of 75.
Since Hooper’s plan would not require any additional facilities, the only costs associated with
the project would be the costs of the sweatshirts and the costs of the sales commissions. The selling
price of the sweatshirts would be $13.50 each. Hooper would pay the students a commission of
$1.50 for each shirt sold.
Required:
1.
2.
To make the project worthwhile, Hooper would require a $1,200 profit for the first three
months of the venture. What level of unit sales and dollar sales would be required to reach this
target net operating income? Show all computations.
Assume that the venture is undertaken and an order is placed for 75 sweatshirts. What would
be Hooper’s break-even point in unit sales and in dollar sales? Show computations and explain
the reasoning behind your answer.
225
226
Chapter 5
PROBLEM 5–25 Changes in Fixed and Variable Expenses; Break-Even and Target Profit Analysis
[LO5–4, LO5–5, LO5–6]
Neptune Company produces toys and other items for use in beach and resort areas. A small, inflatable toy has come onto the market that the company is anxious to produce and sell. The new toy
will sell for $3 per unit. Enough capacity exists in the company’s plant to produce 16,000 units of
the toy each month. Variable expenses to manufacture and sell one unit would be $1.25, and fixed
expenses associated with the toy would total $35,000 per month.
The company’s Marketing Department predicts that demand for the new toy will exceed
the 16,000 units that the company is able to produce. Additional manufacturing space can be
rented from another company at a fixed expense of $1,000 per month. Variable expenses in the
rented facility would total $1.40 per unit, due to somewhat less efficient operations than in the
main plant.
Required:
1.
2.
3.
Compute the monthly break-even point for the new toy in unit sales and in dollar sales.
How many units must be sold each month to make a monthly profit of $12,000?
If the sales manager receives a bonus of 10 cents for each unit sold in excess of the break-even
point, how many units must be sold each month to earn a return of 25% on the monthly investment in fixed expenses?
PROBLEM 5–26 Basic CVP Analysis; Graphing [LO5–1, LO5–2, LO5–4, LO5–5]
The Fashion Shoe Company operates a chain of women’s shoe shops that carry many styles of
shoes that are all sold at the same price. Sales personnel in the shops are paid a substantial commission on each pair of shoes sold (in addition to a small base salary) in order to encourage them
to be aggressive in their sales efforts.
The following worksheet contains cost and revenue data for Shop 48 and is typical of the
company’s many outlets:
Per Pair of
Shoes
Selling price . . . . . . . . . . . . . . . . . . . . . . . . .
$30.00
Variable expenses:
Invoice cost . . . . . . . . . . . . . . . . . . . . . . . .
Sales commission . . . . . . . . . . . . . . . . . . .
$13.50
4.50
Total variable expenses . . . . . . . . . . . . . . . .
$18.00
Annual
Fixed expenses:
Advertising . . . . . . . . . . . . . . . . . . . . . . . .
Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 30,000
20,000
100,000
Total fixed expenses . . . . . . . . . . . . . . . . . . .
$150,000
Required:
1.
2.
3.
4.
5.
6.
Calculate the annual break-even point in unit sales and in dollar sales for Shop 48.
Prepare a CVP graph showing cost and revenue data for Shop 48 from zero shoes up to 17,000
pairs of shoes sold each year. Clearly indicate the break-even point on the graph.
If 12,000 pairs of shoes are sold in a year, what would be Shop 48’s net operating income or loss?
The company is considering paying the store manager of Shop 48 an incentive commission
of 75 cents per pair of shoes (in addition to the salesperson’s commission). If this change is
made, what will be the new break-even point in unit sales and in dollar sales?
Refer to the original data. As an alternative to (4) above, the company is considering paying
the store manager 50 cents commission on each pair of shoes sold in excess of the break-even
point. If this change is made, what will be the shop’s net operating income or loss if 15,000
pairs of shoes are sold?
Refer to the original data. The company is considering eliminating sales commissions entirely
in its shops and increasing fixed salaries by $31,500 annually. If this change is made, what
will be the new break-even point in unit sales and in dollar sales for Shop 48? Would you recommend that the change be made? Explain.
Cost-Volume-Profit Relationships
PROBLEM 5–27 Sales Mix; Break-Even Analysis; Margin of Safety [LO5–7, LO5–9]
Island Novelties, Inc., of Palau makes two products, Hawaiian Fantasy and Tahitian Joy. Present
revenue, cost, and sales data for the two products follow:
Hawaiian
Fantasy
Tahitian
Joy
$15
$9
20,000
$100
$20
5,000
Selling price per unit . . . . . . . . . . . . . . . .
Variable expenses per unit . . . . . . . . . . .
Number of units sold annually . . . . . . . .
Fixed expenses total $475,800 per year.
Required:
1.
2.
3.
Assuming the sales mix given above, do the following:
a. Prepare a contribution format income statement showing both dollar and percent columns for each product and for the company as a whole.
b. Compute the break-even point in dollar sales for the company as a whole and the margin
of safety in both dollars and percent.
The company has developed a new product to be called Samoan Delight. Assume that the
company could sell 10,000 units at $45 each. The variable expenses would be $36 each. The
company’s fixed expenses would not change.
a. Prepare another contribution format income statement, including sales of the Samoan
Delight (sales of the other two products would not change).
b. Compute the company’s new break-even point in dollar sales and the new margin of
safety in both dollars and percent.
The president of the company examines your figures and says, “There’s something strange
here. Our fixed expenses haven’t changed and you show greater total contribution margin
if we add the new product, but you also show our break-even point going up. With greater
contribution margin, the break-even point should go down, not up. You’ve made a mistake
somewhere.” Explain to the president what has happened.
PROBLEM 5–28 Sales Mix; Commission Structure; Multiproduct Break-Even Analysis [LO5–9]
Carbex, Inc., produces cutlery sets out of high-quality wood and steel. The company makes a standard cutlery set and a deluxe set and sells them to retail department stores throughout the country.
The standard set sells for $60, and the deluxe set sells for $75. The variable expenses associated
with each set are given below.
Production costs . . . . . . . . . . . . . . . . . . . . . . . . .
Sales commissions (15% of sales price) . . . . . . .
Standard
Deluxe
$15.00
$9.00
$30.00
$11.25
The company’s fixed expenses each month are:
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative . . . . . . . . . . . . . . . . . . . . . . . . .
$105,000
$21,700
$63,000
Salespersons are paid on a commission basis to encourage them to be aggressive in their sales
efforts. Mary Parsons, the financial vice president, watches sales commissions carefully and has
noted that they have risen steadily over the last year. For this reason, she was shocked to find that
even though sales have increased, profits for the current month—May—are down substantially
from April. Sales, in sets, for the last two months are given below:
April . . . . . . . . .
May . . . . . . . . .
Standard
Deluxe
Total
4,000
1,000
2,000
5,000
6,000
6,000
227
228
Chapter 5
Required:
1.
Prepare contribution format income statements for April and May. Use the following headings:
Standard
Amount
Percent
Deluxe
Amount
Percent
Total
Amount
Percent
Sales . . .
Etc . . . . .
2.
3.
Place the fixed expenses only in the Total column. Do not show percentages for the fixed
expenses.
Explain the difference in net operating incomes between the two months, even though the
same total number of sets was sold in each month.
What can be done to the sales commissions to improve the sales mix?
a. Using April’s sales mix, what is the break-even point in dollar sales?
b. Without doing any calculations, explain whether the break-even points would be higher
or lower with May’s sales mix than April’s sales mix.
PROBLEM 5–29 Changes in Cost Structure; Break-Even Analysis; Operating Leverage; Margin of
Safety [LO5–4, LO5–5, LO5–7, LO5–8]
Morton Company’s contribution format income statement for last month is given below:
Sales (15,000 units 3 $30 per unit) . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . . .
$450,000
315,000
Contribution margin . . . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . .
135,000
90,000
Net operating income . . . . . . . . . . . . . . . . . . . .
$ 45,000
The industry in which Morton Company operates is quite sensitive to cyclical movements in the
economy. Thus, profits vary considerably from year to year according to general economic conditions. The company has a large amount of unused capacity and is studying ways of improving profits.
Required:
1.
2.
3.
4.
New equipment has come onto the market that would allow Morton Company to automate a
portion of its operations. Variable expenses would be reduced by $9 per unit. However, fixed
expenses would increase to a total of $225,000 each month. Prepare two contribution format
income statements, one showing present operations and one showing how operations would
appear if the new equipment is purchased. Show an Amount column, a Per Unit column, and
a Percent column on each statement. Do not show percentages for the fixed expenses.
Refer to the income statements in (1) above. For both present operations and the proposed
new operations, compute (a) the degree of operating leverage, (b) the break-even point in
dollar sales, and (c) the margin of safety in both dollar and percentage terms.
Refer again to the data in (1) above. As a manager, what factor would be paramount in your
mind in deciding whether to purchase the new equipment? (Assume that enough funds are
available to make the purchase.)
Refer to the original data. Rather than purchase new equipment, the marketing manager
argues that the company’s marketing strategy should be changed. Rather than pay sales commissions, which are currently included in variable expenses, the company would pay salespersons fixed salaries and would invest heavily in advertising. The marketing manager claims
this new approach would increase unit sales by 30% without any change in selling price; the
company’s new monthly fixed expenses would be $180,000; and its net operating income
would increase by 20%. Compute the break-even point in dollar sales for the company under
the new marketing strategy. Do you agree with the marketing manager’s proposal?
PROBLEM 5–30 Graphing; Incremental Analysis; Operating Leverage [LO5–2, LO5–4, LO5–5, LO5–6,
LO5–8]
Angie Silva has recently opened The Sandal Shop in Brisbane, Australia, a store that specializes
in fashionable sandals. Angie has just received a degree in business and she is anxious to apply the
principles she has learned to her business. In time, she hopes to open a chain of sandal shops. As a
first step, she has prepared the following analysis for her new store:
Cost-Volume-Profit Relationships
Sales price per pair of sandals . . . . . . . . . . . . .
Variable expenses per pair of sandals . . . . . . .
$40
16
Contribution margin per pair of sandals . . . . . .
$24
Fixed expenses per year:
Building rental . . . . . . . . . . . . . . . . . . . . . . . .
Equipment depreciation . . . . . . . . . . . . . . . .
Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative . . . . . . . . . . . . . . . . . . . . . . .
$15,000
7,000
20,000
18,000
Total fixed expenses . . . . . . . . . . . . . . . . . . . . .
$60,000
Required:
1.
2.
3.
4.
5.
How many pairs of sandals must be sold each year to break even? What does this represent in
total sales dollars?
Prepare a CVP graph or a profit graph for the store from zero pairs up to 4,000 pairs of sandals
sold each year. Indicate the break-even point on your graph.
Angie has decided that she must earn at least $18,000 the first year to justify her time and
effort. How many pairs of sandals must be sold to reach this target profit?
Angie now has two salespersons working in the store—one full time and one part time. It will
cost her an additional $8,000 per year to convert the part-time position to a full-time position.
Angie believes that the change would bring in an additional $25,000 in sales each year. Should
she convert the position? Use the incremental approach. (Do not prepare an income statement.)
Refer to the original data. During the first year, the store sold only 3,000 pairs of sandals and
reported the following operating results:
a.
b.
Sales (3,000 pairs) . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . . .
$120,000
48,000
Contribution margin . . . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . .
72,000
60,000
Net operating income . . . . . . . . . . . . . . . . . . . .
$ 12,000
What is the store’s degree of operating leverage?
Angie is confident that with a more intense sales effort and with a more creative advertising program she can increase sales by 50% next year. What would be the expected
percentage increase in net operating income? Use the degree of operating leverage to
compute your answer.
PROBLEM 5–31 Interpretive Questions on the CVP Graph [LO5–2, LO5–5]
A CVP graph such as the one shown below is a useful technique for showing relationships among
an organization’s costs, volume, and profits.
8
6
1
4
3
9
7
5
2
229
230
Chapter 5
Required:
1.
2.
Identify the numbered components in the CVP graph.
State the effect of each of the following actions on line 3, line 9, and the break-even point. For
line 3 and line 9, state whether the action will cause the line to:
Remain unchanged.
Shift upward.
Shift downward.
Have a steeper slope (i.e., rotate upward).
Have a flatter slope (i.e., rotate downward).
Shift upward and have a steeper slope.
Shift upward and have a flatter slope.
Shift downward and have a steeper slope.
Shift downward and have a flatter slope.
In the case of the break-even point, state whether the action will cause the break-even point to:
Remain unchanged.
Increase.
Decrease.
Probably change, but the direction is uncertain.
Treat each case independently.
x.
Example. Fixed expenses are reduced by $5,000 per period.
Answer (see choices above): Line 3: Shift downward.
Line 9: Remain unchanged.
Break-even point: Decrease.
a.
b.
c.
d.
e.
The unit selling price is increased from $18 to $20.
Unit variable expenses are decreased from $12 to $10.
Fixed expenses are increased by $3,000 per period.
Two thousand more units are sold during the period than were budgeted.
Due to paying salespersons a commission rather than a flat salary, fixed expenses are
reduced by $8,000 per period and unit variable expenses are increased by $3.
Due to an increase in the cost of materials, both unit variable expenses and the selling
price are increased by $2.
Advertising costs are increased by $10,000 per period, resulting in a 10% increase in the
number of units sold.
Due to automating an operation previously done by workers, fixed expenses are increased
by $12,000 per period and unit variable expenses are reduced by $4.
f.
g.
h.
Cases
All applicable cases are available with McGraw-Hill’s Connect® Accounting.
CASE 5–32 Break-Evens for Individual Products in a Multiproduct Company [LO5–5, LO5–9]
Cheryl Montoya picked up the phone and called her boss, Wes Chan, the vice president of marketing at Piedmont Fasteners Corporation: “Wes, I’m not sure how to go about answering the questions that came up at the meeting with the president yesterday.”
“What’s the problem?”
“The president wanted to know the break-even point for each of the company’s products, but
I am having trouble figuring them out.”
“I’m sure you can handle it, Cheryl. And, by the way, I need your analysis on my desk tomorrow morning at 8:00 sharp in time for the follow-up meeting at 9:00.”
Piedmont Fasteners Corporation makes three different clothing fasteners in its manufacturing
facility in North Carolina. Data concerning these products appear below:
Normal annual sales volume . . . . . . . .
Unit selling price . . . . . . . . . . . . . . . . . .
Variable expense per unit . . . . . . . . . .
Total fixed expenses are $400,000 per year.
Velcro
Metal
Nylon
100,000
$1.65
$1.25
200,000
$1.50
$0.70
400,000
$0.85
$0.25
Cost-Volume-Profit Relationships
All three products are sold in highly competitive markets, so the company is unable to raise its
prices without losing unacceptable numbers of customers.
The company has an extremely effective lean production system, so there are no beginning or
ending work in process or finished goods inventories.
Required:
1.
2.
What is the company’s over-all break-even point in dollar sales?
Of the total fixed expenses of $400,000, $20,000 could be avoided if the Velcro product
is dropped, $80,000 if the Metal product is dropped, and $60,000 if the Nylon product is
dropped. The remaining fixed expenses of $240,000 consist of common fixed expenses such
as administrative salaries and rent on the factory building that could be avoided only by going
out of business entirely.
a. What is the break-even point in unit sales for each product?
b. If the company sells exactly the break-even quantity of each product, what will be the
overall profit of the company? Explain this result.
CASE 5–33 Cost Structure; Break-Even and Target Profit Analysis [LO5–4, LO5–5, LO5–6]
Pittman Company is a small but growing manufacturer of telecommunications equipment. The
company has no sales force of its own; rather, it relies completely on independent sales agents to
market its products. These agents are paid a sales commission of 15% for all items sold.
Barbara Cheney, Pittman’s controller, has just prepared the company’s budgeted income statement for next year. The statement follows:
Pittman Company
Budgeted Income Statement
For the Year Ended December 31
Sales . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing expenses:
Variable . . . . . . . . . . . . . . . . . . . . . .
Fixed overhead . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Commissions to agents . . . . . . . . . .
Fixed marketing expenses . . . . . . . .
Fixed administrative expenses . . . .
$16,000,000
$7,200,000
2,340,000
9,540,000
6,460,000
2,400,000
120,000*
1,800,000
4,320,000
Net operating income . . . . . . . . . . . . . .
Fixed interest expenses . . . . . . . . . . . .
2,140,000
540,000
Income before income taxes . . . . . . . .
Income taxes (30%) . . . . . . . . . . . . . .
1,600,000
480,000
Net income . . . . . . . . . . . . . . . . . . . . .
$ 1,120,000
*Primarily depreciation on storage facilities.
As Barbara handed the statement to Karl Vecci, Pittman’s president, she commented, “I went
ahead and used the agents’ 15% commission rate in completing these statements, but we’ve just
learned that they refuse to handle our products next year unless we increase the commission rate
to 20%.”
“That’s the last straw,” Karl replied angrily. “Those agents have been demanding more and
more, and this time they’ve gone too far. How can they possibly defend a 20% commission rate?”
“They claim that after paying for advertising, travel, and the other costs of promotion, there’s
nothing left over for profit,” replied Barbara.
“I say it’s just plain robbery,” retorted Karl. “And I also say it’s time we dumped those guys and
got our own sales force. Can you get your people to work up some cost figures for us to look at?”
“We’ve already worked them up,” said Barbara. “Several companies we know about pay a
7.5% commission to their own salespeople, along with a small salary. Of course, we would have
to handle all promotion costs, too. We figure our fixed expenses would increase by $2,400,000 per
year, but that would be more than offset by the $3,200,000 (20% 3 $16,000,000) that we would
avoid on agents’ commissions.”
231
232
Chapter 5
The breakdown of the $2,400,000 cost follows:
Salaries:
Sales manager . . . . . . . . . . . . . . . . . . . . . .
Salespersons . . . . . . . . . . . . . . . . . . . . . . .
Travel and entertainment . . . . . . . . . . . . . . . .
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 100,000
600,000
400,000
1,300,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$2,400,000
“Super,” replied Karl. “And I noticed that the $2,400,000 is just what we’re paying the agents
under the old 15% commission rate.”
“It’s even better than that,” explained Barbara. “We can actually save $75,000 a year because
that’s what we’re having to pay the auditing firm now to check out the agents’ reports. So our overall administrative expenses would be less.”
“Pull all of these numbers together and we’ll show them to the executive committee tomorrow,” said Karl. “With the approval of the committee, we can move on the matter immediately.”
Required:
1.
2.
3.
4.
5.
Compute Pittman Company’s break-even point in dollar sales for next year assuming:
a. The agents’ commission rate remains unchanged at 15%.
b. The agents’ commission rate is increased to 20%.
c. The company employs its own sales force.
Assume that Pittman Company decides to continue selling through agents and pays the 20%
commission rate. Determine the volume of sales that would be required to generate the same
net income as contained in the budgeted income statement for next year.
Determine the volume of sales at which net income would be equal regardless of whether
Pittman Company sells through agents (at a 20% commission rate) or employs its own sales
force.
Compute the degree of operating leverage that the company would expect to have on December 31 at the end of next year assuming:
a. The agents’ commission rate remains unchanged at 15%.
b. The agents’ commission rate is increased to 20%.
c. The company employs its own sales force.
Use income before income taxes in your operating leverage computation.
Based on the data in (1) through (4) above, make a recommendation as to whether the company should continue to use sales agents (at a 20% commission rate) or employ its own sales
force. Give reasons for your answer.
(CMA, adapted)
CHAPTER 6
Variable Costing and Segment Reporting:
Tools for Management
Misguided Incentives in the Auto Industry
BUSIN ESS FO CUS
LEARNING OBJECTIVES
After studying Chapter 6, you should be
able to:
When the economy tanks, automakers, such as General Motors and
Chrysler, often “flood the market” with a supply of vehicles that far exceeds
customer demand. They pursue this course of action even though it tarnishes
their brand image and increases their auto storage costs, tire replacement
costs, customer rebate costs, and advertising costs. This begs the question
why would managers knowingly produce more vehicles than are demanded
by customers?
In the auto industry, a manager’s bonus is often influenced by her company’s reported profits; thus, there is a strong incentive to boost profits by
producing more units. How can this be done you ask? It would seem logical that producing more units would have no impact on profits unless the
units were sold, right? Wrong! As we will discover in this chapter, absorption
costing—the most widely used method of determining product costs—can
artificially increase profits when managers choose to increase the quantity of
units produced. ■
Source: Marielle Segarra, “Lots of Trouble,” CFO, March 2012, pp. 29–30.
LO6–1
Explain how variable costing differs
from absorption costing and
compute unit product costs under
each method.
LO6–2
Prepare income statements using
both variable and absorption
costing.
LO6–3
Reconcile variable costing and
absorption costing net operating
incomes and explain why the two
amounts differ.
LO6–4
Prepare a segmented income
statement that differentiates
traceable fixed costs from
common fixed costs and use it to
make decisions.
LO6–5
Compute companywide and
segment break-even points for
a company with traceable fixed
costs.
LO6–6
(Appendix 6A) Prepare an income
statement using super-variable
costing and reconcile this
approach with variable costing.
233
234
Chapter 6
his chapter describes two applications of the contribution for-
T
mat income statements that were introduced in earlier chapters. First, it explains
how manufacturing companies can prepare variable costing income statements,
which rely on the contribution format, for internal decision making purposes.
The variable costing approach will be contrasted with absorption costing income statements, which were discussed in Chapter 3 and are generally used for external reports.
Ordinarily, variable costing and absorption costing produce different net operating
income figures, and the difference can be quite large. In addition to showing how these
two methods differ, we will describe the advantages of variable costing for internal
reporting purposes and we will show how management decisions can be affected by the
costing method chosen.
Second, the chapter explains how the contribution format can be used to prepare segmented income statements. In addition to companywide income statements, managers
need to measure the profitability of individual segments of their organizations. A segment
is a part or activity of an organization about which managers would like cost, revenue, or
profit data. This chapter explains how to create contribution format income statements
that report profit data for business segments, such as divisions, individual stores, geographic regions, customers, and product lines.
Overview of Variable and Absorption Costing
LO6–1
Explain how variable costing
differs from absorption costing
and compute unit product costs
under each method.
As you begin to read about variable and absorption costing income statements in the
coming pages, focus your attention on three key concepts. First, both income statement formats include product costs and period costs, although they define these cost
classifications differently. Second, variable costing income statements are grounded in
the contribution format. They categorize expenses based on cost behavior—variable
expenses are reported separately from fixed expenses. Absorption costing income statements ignore variable and fixed cost distinctions. Third, as mentioned in the paragraph
above, variable and absorption costing net operating income figures often differ from
one another. The reason for these differences always relates to the fact the variable costing and absorption costing income statements account for fixed manufacturing overhead
differently. Pay very close attention to the two different ways that variable costing and
absorption costing account for fixed manufacturing overhead.
Variable Costing
Under variable costing, only those manufacturing costs that vary with output are
treated as product costs. This would usually include direct materials, direct labor, and
the variable portion of manufacturing overhead. Fixed manufacturing overhead is not
treated as a product cost under this method. Rather, fixed manufacturing overhead is
treated as a period cost and, like selling and administrative expenses, it is expensed in
its entirety each period. Consequently, the cost of a unit of product in inventory or in
cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost. Variable costing is sometimes referred to as direct costing or
marginal costing.
Absorption Costing
As discussed in Chapter 3, absorption costing treats all manufacturing costs as product
costs, regardless of whether they are variable or fixed. The cost of a unit of product under
the absorption costing method consists of direct materials, direct labor, and both variable
and fixed manufacturing overhead. Thus, absorption costing allocates a portion of fixed
Variable Costing and Segment Reporting: Tools for Management
235
manufacturing overhead cost to each unit of product, along with the variable manufacturing costs. Because absorption costing includes all manufacturing costs in product costs, it
is frequently referred to as the full cost method.
Selling and Administrative Expenses
Selling and administrative expenses are never treated as product costs, regardless of the
costing method. Thus, under absorption and variable costing, variable and fixed selling and administrative expenses are always treated as period costs and are expensed as
incurred.
Summary of Differences The essential difference between variable costing and
absorption costing, as illustrated in Exhibit 6–1, is how each method accounts for fixed
manufacturing overhead costs—all other costs are treated the same under the two methods. In absorption costing, fixed manufacturing overhead costs are included as part of
the costs of work in process inventories. When units are completed, these costs are transferred to finished goods and only when the units are sold do these costs flow through to
the income statement as part of cost of goods sold. In variable costing, fixed manufacturing overhead costs are considered to be period costs—just like selling and administrative
costs—and are taken immediately to the income statement as period expenses.
EXHIBIT 6–1
Variable Costing versus
Absorption Costing
Costs
Manufacturing costs
Balance Sheet
Raw materials
purchases
Raw Materials inventory
Direct materials
used in production
Direct labor
Variable
manufacturing
overhead
Ab
so
co rptio
sti
ng n
Work in Process inventory
Goods completed
(cost of goods
manufactured)
Income Statement
Cost of Goods Sold
Finished Goods inventory
Fixed
manufacturing
overhead
Goods
sold
Variab
le
costin
g
Nonmanufacturing costs
Selling and
administrative
Period Expenses
236
Chapter 6
Variable and Absorption Costing—An Example
To illustrate the difference between variable costing and absorption costing, consider
Weber Light Aircraft, a company that produces light recreational aircraft. Data concerning the company’s operations appear below:
Per Aircraft
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Variable selling and administrative expenses . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . .
Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . .
Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Per Month
$100,000
$19,000
$5,000
$1,000
$70,000
$10,000
$20,000
January
February
March
0
1
1
0
0
2
1
1
1
4
5
0
As you review the data above, it is important to realize that for the months of January,
February, and March, the selling price per aircraft, variable cost per aircraft, and total
monthly fixed expenses never change. The only variables that change in this example
are the number of units produced (January 5 1 unit produced; February 5 2 units produced; March 5 4 units produced) and the number of units sold (January 5 1 unit sold;
February 5 1 unit sold; March 5 5 units sold).
We will first construct the company’s variable costing income statements for January,
February, and March. Then we will show how the company’s net operating income would
be determined for the same months using absorption costing.
Variable Costing Contribution Format Income Statement
LO6–2
Prepare income statements
using both variable and
absorption costing.
To prepare the company’s variable costing income statements for January, February, and
March we begin by computing the unit product cost. Under variable costing, product
costs consist solely of variable production costs. At Weber Light Aircraft, the variable
production cost per unit is $25,000, determined as follows:
Variable Costing Unit Product Cost
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . .
Variable costing unit product cost . . . . . . . . . . . . . . . . . . .
$19,000
5,000
1,000
$25,000
Since each month’s variable production cost is $25,000 per aircraft, the variable costing
cost of goods sold for all three months can be easily computed as follows:
Variable Costing Cost of Goods Sold
January
Variable production cost (a) . . . . . . . . . . . . . . . . .
Units sold (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable cost of goods sold (a) 3 (b) . . . . . . . . . .
$25,000
1
$25,000
February
March
$25,000
1
$25,000
$25,000
5
$125,000
Variable Costing and Segment Reporting: Tools for Management
237
And the company’s total selling and administrative expense would be derived as follows:
Selling and Administrative Expenses
January
Variable selling and administrative expense
(@ $10,000 per unit sold) . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expense . . . . . . .
Total selling and administrative expense . . . . . . . .
$10,000
20,000
$30,000
February
March
$10,000
20,000
$30,000
$50,000
20,000
$70,000
Putting it all together, the variable costing income statements would appear as shown in
Exhibit 6–2. Notice, the contribution format has been used in these income statements.
Also, the monthly fixed manufacturing overhead costs ($70,000) have been recorded as a
period expense in the month incurred.
Variable Costing Contribution Format Income Statements
January
February
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses:
Variable cost of goods sold . . . . . . . . . . . .
Variable selling and administrative
expense . . . . . . . . . . . . . . . . . . . . . . . . .
Total variable expenses . . . . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . . . . . . . . .
Fixed expenses:
Fixed manufacturing overhead . . . . . . . . . .
Fixed selling and administrative expense . . .
Total fixed expenses . . . . . . . . . . . . . . . . . . .
Net operating income (loss) . . . . . . . . . . . . . .
March
$100,000
$100,000
$500,000
25,000
25,000
125,000
10,000
35,000
65,000
10,000
35,000
65,000
50,000
175,000
325,000
70,000
20,000
90,000
$ (25,000)
70,000
20,000
90,000
$ (25,000)
70,000
20,000
90,000
$235,000
A simple method for understanding how Weber Light Aircraft computed its variable
costing net operating income figures is to focus on the contribution margin per aircraft
sold, which is computed as follows:
Contribution Margin per Aircraft Sold
Selling price per aircraft . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable production cost per aircraft . . . . . . . . . . . . . . . . . . . .
Variable selling and administrative expense per aircraft . . . . .
Contribution margin per aircraft . . . . . . . . . . . . . . . . . . . . . . .
$100,000
$25,000
10,000
35,000
$ 65,000
The variable costing net operating income for each period can always be computed by
multiplying the number of units sold by the contribution margin per unit and then subtracting total fixed costs. For Weber Light Aircraft these computations would appear as follows:
Number of aircraft sold . . . . . . . . . . . . . . .
Contribution margin per aircraft . . . . . . . . .
Total contribution margin . . . . . . . . . . . . . .
Total fixed expenses . . . . . . . . . . . . . . . . . .
Net operating income (loss) . . . . . . . . . . . .
January
February
March
1
3 $65,000
$65,000
90,000
$(25,000)
1
3 $65,000
$65,000
90,000
$(25,000)
5
3 $65,000
$325,000
90,000
$235,000
Notice, January and February have the same net operating loss. This occurs because one
aircraft was sold in each month and, as previously mentioned, the selling price per aircraft, variable cost per aircraft, and total monthly fixed expenses remain constant.
EXHIBIT 6–2
Variable Costing Income
Statements
238
Chapter 6
Absorption Costing Income Statement
As we begin the absorption costing portion of the example, remember that the only reason absorption costing income differs from variable costing is that the methods account
for fixed manufacturing overhead differently. Under absorption costing, fixed manufacturing overhead is included in product costs. In variable costing, fixed manufacturing
overhead is not included in product costs and instead is treated as a period expense just
like selling and administrative expenses.
The first step in preparing Weber’s absorption costing income statements for January,
February, and March is to determine the company’s unit product costs for each month as
follows1:
Absorption Costing Unit Product Cost
January
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . .
Fixed manufacturing overhead ($70,000 4 1 unit
produced in January; $70,000 4 2 units produced in
February; $70,000 4 4 units produced in March) . . .
Absorption costing unit product cost . . . . . . . . . . . .
February
March
$19,000
5,000
1,000
$19,000
5,000
1,000
$19,000
5,000
1,000
70,000
$95,000
35,000
$60,000
17,500
$42,500
Notice that in each month, Weber’s fixed manufacturing overhead cost of $70,000 is
divided by the number of units produced to determine the fixed manufacturing overhead
cost per unit.
Given these unit product costs, the company’s absorption costing net operating
income in each month would be determined as shown in Exhibit 6–3.
The sales for all three months in Exhibit 6–3 are the same as the sales shown in the
variable costing income statements. The January cost of goods sold consists of one unit
produced during January at a cost of $95,000 according to the absorption costing system. The February cost of goods sold consists of one unit produced during February at
a cost of $60,000 according to the absorption costing system. The March cost of goods
sold ($230,000) consists of one unit produced during February at an absorption cost
of $60,000 plus four units produced in March with a total absorption cost of $170,000
(5 4 units produced 3 $42,500 per unit). The selling and administrative expenses equal
the amounts reported in the variable costing income statements; however they are reported
as one amount rather than being separated into variable and fixed components.
EXHIBIT 6–3
Absorption Costing Income
Statements
Absorption Costing Income Statements
January
February
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold ($95,000 3 1
unit; $60,000 3 1 unit;
$60,000 3 1 unit 1 $42,500 3 4 units) . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . .
Net operating income (loss) . . . . . . . . . . . . . .
1
March
$100,000
$100,000
$500,000
95,000
5,000
30,000
$ (25,000)
60,000
40,000
30,000
$ 10,000
230,000
270,000
70,000
$200,000
For simplicity, we assume in this section that an actual costing system is used in which actual costs
are spread over the units produced during the period. If a predetermined overhead rate were used, the
analysis would be similar, but more complex.
Variable Costing and Segment Reporting: Tools for Management
239
Note that even though sales were exactly the same in January and February and the
cost structure did not change, net operating income was $35,000 higher in February than
in January under absorption costing. This occurs because one aircraft produced in February is not sold until March. This aircraft has $35,000 of fixed manufacturing overhead
attached to it that was incurred in February, but will not be recorded as part of cost of
goods sold until March.
Contrasting the variable costing and absorption costing income statements in Exhibits
6–2 and 6–3, note that net operating income is the same in January under variable costing
and absorption costing, but differs in the other two months. We will discuss this in some
depth shortly. Also note that the format of the variable costing income statement differs
from the absorption costing income statement. An absorption costing income statement
categorizes costs by function—manufacturing versus selling and administrative. All of
the manufacturing costs flow through the absorption costing cost of goods sold and all of
the selling and administrative expenses are listed separately as period expenses. In contrast, in the contribution approach, costs are categorized according to how they behave.
All of the variable expenses are listed together and all of the fixed expenses are listed
together. The variable expenses category includes manufacturing costs (i.e., variable cost
of goods sold) as well as selling and administrative expenses. The fixed expenses category also includes both manufacturing costs and selling and administrative expenses.
THE BEHAVIORAL SIDE OF CALCULATING UNIT PRODUCT COSTS
IN BUSINESS
Andreas STIHL, a manufacturer of chain saws and other landscaping products, asked its U.S. subsidiary, STIHL Inc., to replace its absorption costing income statements with the variable costing
approach. From a computer systems standpoint, the change was not disruptive because STIHL
used an enterprise system called SAP that accommodates both absorption and variable costing.
However, from a behavioral standpoint, STIHL felt the change could be very disruptive. For example, STIHL’s senior managers were keenly aware that the variable costing approach reported lower
unit product costs than the absorption costing approach. Given this reality, the sales force might be
inclined to erroneously conclude that each product had magically become more profitable, thereby
justifying ill-advised price reductions. Because of behavioral concerns such as this, STIHL worked
hard to teach its employees how to interpret a variable costing income statement.
Source: Carl S. Smith, “Going for GPK: STIHL Moves Toward This Costing System in the United States,” Strategic Finance, April 2005, pp. 36–39.
Reconciliation of Variable Costing with Absorption Costing Income
As noted earlier, variable costing and absorption costing net operating incomes may not
be the same. In the case of Weber Light Aircraft, the net operating incomes are the same
in January, but differ in the other two months. These differences occur because under
absorption costing some fixed manufacturing overhead is capitalized in inventories (i.e.,
included in product costs) rather than being immediately expensed on the income statement. If inventories increase during a period, under absorption costing some of the fixed
manufacturing overhead of the current period will be deferred in ending inventories.
For example, in February two aircraft were produced and each carried with it $35,000
(5 $70,000 4 2 aircraft produced) in fixed manufacturing overhead. Since only one aircraft was sold, $35,000 of this fixed manufacturing overhead was on February’s absorption costing income statement as part of cost of goods sold, but $35,000 would have been
on the balance sheet as part of finished goods inventories. In contrast, under variable costing all of the $70,000 of fixed manufacturing overhead appeared on the February income
LO6–3
Reconcile variable costing
and absorption costing net
operating incomes and explain
why the two amounts differ.
240
Chapter 6
statement as a period expense. Consequently, net operating income was higher under
absorption costing than under variable costing by $35,000 in February. This was reversed
in March when four units were produced, but five were sold. In March, under absorption
costing $105,000 of fixed manufacturing overhead was included in cost of goods sold
($35,000 for the unit produced in February and sold in March plus $17,500 for each of
the four units produced and sold in March), but only $70,000 was recognized as a period
expense under variable costing. Hence, the net operating income in March was $35,000
lower under absorption costing than under variable costing.
In general, when the units produced exceed unit sales and hence inventories increase,
net operating income is higher under absorption costing than under variable costing. This
occurs because some of the fixed manufacturing overhead of the period is deferred in
inventories under absorption costing. In contrast, when unit sales exceed the units produced and hence inventories decrease, net operating income is lower under absorption
costing than under variable costing. This occurs because some of the fixed manufacturing overhead of previous periods is released from inventories under absorption costing.
When the units produced and unit sales are equal, no change in inventories occurs and
absorption costing and variable costing net operating incomes are the same.2
Variable costing and absorption costing net operating incomes can be reconciled by
determining how much fixed manufacturing overhead was deferred in, or released from,
inventories during the period:
Fixed Manufacturing Overhead Deferred in, or Released from,
Inventories under Absorption Costing
January February
Fixed manufacturing overhead in
ending inventories . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead in beginning
inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead deferred in
(released from) inventories . . . . . . . . . . . . . . . .
March
$0
$35,000
$
0
0
0
35,000
$0
$35,000
$(35,000)
In equation form, the fixed manufacturing overhead that is deferred in or released
from inventories can be determined as follows:
Manufacturing overhead
Fixed manufacturing
Fixed manufacturing
deferred in
overhead in
overhead in
5
2
(released from) inventory
ending inventories
beginning inventories
The reconciliation would then be reported as shown in Exhibit 6–4:
EXHIBIT 6–4
Reconciliation of Variable
Costing and Absorption Costing
Net Operating Incomes
Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes
January February
March
Variable costing net operating income (loss) . . . . . $(25,000) $(25,000) $235,000
Add (deduct) fixed manufacturing overhead
deferred in (released from) inventory under
0
35,000
(35,000)
absorption costing . . . . . . . . . . . . . . . . . . . . . . . .
Absorption costing net operating income (loss) . . . $(25,000) $ 10,000 $200,000
2
These general statements about the relation between variable costing and absorption costing net operating income assume LIFO is used to value inventories. Even when LIFO is not used, the general statements tend to be correct. Although U.S. GAAP allows LIFO and FIFO inventory flow assumptions,
International Financial Reporting Standards do not allow a LIFO inventory flow assumption.
Variable Costing and Segment Reporting: Tools for Management
Relation between
Production and Sales
for the Period
Effect on
Inventories
Relation between
Absorption and Variable
Costing Net
Operating Incomes
Units produced 5
Units sold
No change in inventories
Absorption costing net
operating income 5
Variable costing net
operating income
Units produced .
Units sold
Inventories increase
Absorption costing net
operating income .
Variable costing net
operating income*
Units produced ,
Units sold
Inventories decrease
Absorption costing net
operating income ,
Variable costing net
operating income†
*Net operating income is higher under absorption costing because fixed manufacturing
overhead cost is deferred in inventory under absorption costing as inventories increase.
†
Net operating income is lower under absorption costing because fixed manufacturing
overhead cost is released from inventory under absorption costing as inventories
decrease.
Again note that the difference between variable costing net operating income and absorption costing net operating income is entirely due to the amount of fixed manufacturing
overhead that is deferred in, or released from, inventories during the period under absorption costing. Changes in inventories affect absorption costing net operating income—they
do not affect variable costing net operating income, providing that variable manufacturing costs per unit are stable.
The reasons for differences between variable and absorption costing net operating
incomes are summarized in Exhibit 6–5. When the units produced equal the units sold, as
in January for Weber Light Aircraft, absorption costing net operating income will equal
variable costing net operating income. This occurs because when production equals sales,
all of the fixed manufacturing overhead incurred in the current period flows through to
the income statement under both methods. For companies that use Lean Production, the
number of units produced tends to equal the number of units sold. This occurs because
goods are produced in response to customer orders, thereby eliminating finished goods
inventories and reducing work in process inventory to almost nothing. So, when a company uses Lean Production differences in variable costing and absorption costing net
operating income will largely disappear.
When the units produced exceed the units sold, absorption costing net operating
income will exceed variable costing net operating income. This occurs because inventories have increased; therefore, under absorption costing some of the fixed manufacturing
overhead incurred in the current period is deferred in ending inventories on the balance
sheet, whereas under variable costing all of the fixed manufacturing overhead incurred
in the current period flows through to the income statement. In contrast, when the units
produced are less than the units sold, absorption costing net operating income will be
less than variable costing net operating income. This occurs because inventories have
decreased; therefore, under absorption costing fixed manufacturing overhead that had
been deferred in inventories during a prior period flows through to the current period’s
income statement together with all of the fixed manufacturing overhead incurred during
the current period. Under variable costing, just the fixed manufacturing overhead of the
current period flows through to the income statement.
241
EXHIBIT 6–5
Comparative Income Effects—
Absorption and Variable Costing
242
Chapter 6
IN BUSINESS
LEAN MANUFACTURING SHRINKS INVENTORIES
Conmed, a surgical device maker in Utica, New York, switched to lean manufacturing by replacing its assembly lines with U-shaped production cells. It also started producing only enough units
to satisfy customer demand rather than producing as many units as possible and storing them in
warehouses. The company calculated that its customers use one of its disposable surgical devices
every 90 seconds, so that is precisely how often it produces a new unit. Its assembly area for
fluid-injection devices used to occupy 3,300 square feet of space and contained $93,000 worth
of parts. Now the company produces its fluid-injection devices in 660 square feet of space while
maintaining only $6,000 of parts inventory.
When Conmed adopted lean manufacturing, it substantially reduced its finished goods inventories. What impact do you think this initial reduction in inventories may have had on net operating
income? Why?
Source: Pete Engardio, “Lean and Mean Gets Extreme,” BusinessWeek, March 23 and 30, 2009, pp. 60–62.
Advantages of Variable Costing and the Contribution Approach
Variable costing, together with the contribution approach, offers appealing advantages
for internal reports. This section discusses three of those advantages.
Enabling CVP Analysis
CVP analysis requires that we break costs down into their fixed and variable components.
Because variable costing income statements categorize costs as fixed and variable, it is
much easier to use this income statement format to perform CVP analysis than attempting to use the absorption costing format, which mixes together fixed and variable costs.
Moreover, absorption costing net operating income may or may not agree with the
results of CVP analysis. For example, let’s suppose that you are interested in computing
the sales that would be necessary to generate a target profit of $235,000 at Weber Light
Aircraft. A CVP analysis based on the January variable costing income statement from
Exhibit 6–2 would proceed as follows:
Sales (a) . . . . . . . . . . . . . . . . . . . . . . . . . . .
Contribution margin (b) . . . . . . . . . . . . . . .
Contribution margin ratio (b) 4 (a) . . . . . . .
Total fixed expenses . . . . . . . . . . . . . . . . .
$100,000
$65,000
65%
$90,000
Target profit 1 Fixed expenses
Dollar sales to attain target profit 5 _________________________
CM ratio
$235,000 1 $90,000
5 _________________ 5 $500,000
0.65
Thus, a CVP analysis based on the January variable costing income statement predicts
that the net operating income would be $235,000 when sales are $500,000. And indeed,
the net operating income under variable costing is $235,000 when the sales are $500,000
Variable Costing and Segment Reporting: Tools for Management
in March. However, the net operating income under absorption costing is not $235,000
in March, even though the sales are $500,000. Why is this? The reason is that under
absorption costing, net operating income can be distorted by changes in inventories. In
March, inventories decreased, so some of the fixed manufacturing overhead that had been
deferred in February’s ending inventories was released to the March income statement,
resulting in a net operating income that is $35,000 lower than the $235,000 predicted by
CVP analysis. If inventories had increased in March, the opposite would have occurred—
the absorption costing net operating income would have been higher than the $235,000
predicted by CVP analysis.
Explaining Changes in Net Operating Income
The variable costing income statements in Exhibit 6–2 are clear and easy to understand.
All other things the same, when sales go up, net operating income goes up. When sales go
down, net operating income goes down. When sales are constant, net operating income is
constant. The number of units produced does not affect net operating income.
Absorption costing income statements can be confusing and are easily misinterpreted. Look again at the absorption costing income statements in Exhibit 6–3; a manager might wonder why net operating income went up from January to February even
though sales were exactly the same. Was it a result of lower selling costs, more efficient
operations, or was it some other factor? In fact, it was simply because the number of
units produced exceeded the number of units sold in February and so some of the fixed
manufacturing overhead costs were deferred in inventories in that month. These costs
have not gone away—they will eventually flow through to the income statement in a later
period when inventories go down. There is no way to tell this from the absorption costing
income statements.
To avoid mistakes when absorption costing is used, readers of financial statements
should be alert to changes in inventory levels. Under absorption costing, if inventories
increase, fixed manufacturing overhead costs are deferred in inventories, which in turn
increases net operating income. If inventories decrease, fixed manufacturing overhead
costs are released from inventories, which in turn decreases net operating income. Thus,
when absorption costing is used, fluctuations in net operating income can be caused by
changes in inventories as well as changes in sales.
Supporting Decision Making
The variable costing method correctly identifies the additional variable costs that will be
incurred to make one more unit. It also emphasizes the impact of fixed costs on profits.
The total amount of fixed manufacturing costs appears explicitly on the income statement, highlighting that the whole amount of fixed manufacturing costs must be covered
for the company to be truly profitable. In the Weber Light Aircraft example, the variable costing income statements correctly report that the cost of producing another unit is
$25,000 and they explicitly recognize that $70,000 of fixed manufactured overhead must
be covered to earn a profit.
Under absorption costing, fixed manufacturing overhead costs appear to be variable
with respect to the number of units sold, but they are not. For example, in January, the
absorption unit product cost at Weber Light Aircraft is $95,000, but the variable portion
of this cost is only $25,000. The fixed overhead costs of $70,000 are commingled with
variable production costs, thereby obscuring the impact of fixed overhead costs on profits. Because absorption unit product costs are stated on a per unit basis, managers may
mistakenly believe that if another unit is produced, it will cost the company $95,000.
But of course it would not. The cost of producing another unit would be only $25,000.
Misinterpreting absorption unit product costs as variable can lead to many problems,
including inappropriate pricing decisions and decisions to drop products that are in
fact profitable.
243
244
Chapter 6
Segmented Income Statements and the Contribution Approach
LO6–4
Prepare a segmented income
statement that differentiates
traceable fixed costs from
common fixed costs and use it
to make decisions.
In the remainder of the chapter, we’ll learn how to use the contribution approach to construct income statements for business segments. These segmented income statements are
useful for analyzing the profitability of segments, making decisions, and measuring the
performance of segment managers.
Traceable and Common Fixed Costs and the Segment Margin
You need to understand three new terms to prepare segmented income statements using
the contribution approach—traceable fixed cost, common fixed cost, and segment margin.
A traceable fixed cost of a segment is a fixed cost that is incurred because of the
existence of the segment—if the segment had never existed, the fixed cost would not
have been incurred; and if the segment were eliminated, the fixed cost would disappear.
Examples of traceable fixed costs include the following:
•
•
•
The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the
Fritos business segment of PepsiCo.
The maintenance cost for the building in which Boeing 747s are assembled is a
traceable fixed cost of the 747 business segment of Boeing.
The liability insurance at Disney World is a traceable fixed cost of the Disney World
business segment of The Walt Disney Corporation.
A common fixed cost is a fixed cost that supports the operations of more than one
segment, but is not traceable in whole or in part to any one segment. Even if a segment
were entirely eliminated, there would be no change in a true common fixed cost. For
example:
•
•
•
The salary of the CEO of General Motors is a common fixed cost of the various
divisions of General Motors.
The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the
store’s various departments—groceries, produce, bakery, meat, and so forth.
The cost of the receptionist’s salary at an office shared by a number of doctors is a
common fixed cost of the doctors. The cost is traceable to the office, but not to individual doctors.
To prepare a segmented income statement, variable expenses are deducted from sales
to yield the contribution margin for the segment. The contribution margin tells us what
happens to profits as volume changes—holding a segment’s capacity and fixed costs constant. The contribution margin is especially useful in decisions involving temporary uses
of capacity such as special orders. These types of decisions often involve only variable
costs and revenues—the two components of contribution margin.
The segment margin is obtained by deducting the traceable fixed costs of a segment from the segment’s contribution margin. It represents the margin available after
a segment has covered all of its own costs. The segment margin is the best gauge of the
long-run profitability of a segment because it includes only those costs that are caused by
the segment. If a segment can’t cover its own costs, then that segment probably should be
dropped (unless it has important side effects on other segments). Notice, common fixed
costs are not allocated to segments.
From a decision-making point of view, the segment margin is most useful in major
decisions that affect capacity such as dropping a segment. By contrast, as we noted earlier, the contribution margin is most useful in decisions involving short-run changes in
volume, such as pricing special orders that involve temporary use of existing capacity.
Variable Costing and Segment Reporting: Tools for Management
HAS THE INTERNET KILLED CATALOGS?
Smith & Hawken, an outdoor-accessories retailer, has experienced growing Internet sales and
declining catalog sales. These trends seem consistent with conventional wisdom, which suggests
that the Internet will make catalogs obsolete. Yet, Smith & Hawken, like many retailers with growing Internet sales, has no plans to discontinue its catalogs. In fact, the total number of catalogs
mailed in the United States by all companies has jumped from 16.6 billion in 2002 to 19.2 billion
in 2005. Why?
Catalog shoppers and Internet shoppers are not independent customer segments. Catalog
shoppers frequently choose to complete their sales transactions online rather than placing telephone orders. This explains why catalogs remain a compelling marketing medium even though
catalog sales are declining for many companies. If retailers separately analyze catalog sales and
Internet sales, they may discontinue the catalogs segment while overlooking the adverse impact of
this decision on Internet segment margins.
Source: Louise Lee, “Catalogs, Catalogs, Everywhere,” BusinessWeek, December 4, 2006, pp. 32–34.
Identifying Traceable Fixed Costs
The distinction between traceable and common fixed costs is crucial in segment reporting
because traceable fixed costs are charged to segments and common fixed costs are not. In
an actual situation, it is sometimes hard to determine whether a cost should be classified
as traceable or common.
The general guideline is to treat as traceable costs only those costs that would disappear over time if the segment itself disappeared. For example, if one division within a
company were sold or discontinued, it would no longer be necessary to pay that division
manager’s salary. Therefore the division manager’s salary would be classified as a traceable fixed cost of the division. On the other hand, the president of the company undoubtedly would continue to be paid even if one of many divisions was dropped. In fact, he
or she might even be paid more if dropping the division was a good idea. Therefore,
the president’s salary is common to the company’s divisions and should not be charged
to them.
When assigning costs to segments, the key point is to resist the temptation to allocate
costs (such as depreciation of corporate facilities) that are clearly common and that will
continue regardless of whether the segment exists or not. Any allocation of common costs
to segments reduces the value of the segment margin as a measure of long-run segment
profitability and segment performance.
Traceable Costs Can Become Common Costs
Fixed costs that are traceable to one segment may be a common cost of another segment.
For example, United Airlines might want a segmented income statement that shows the
segment margin for a particular flight from Chicago to Paris further broken down into
first-class, business-class, and economy-class segment margins. The airline must pay a
substantial landing fee at Charles DeGaulle airport in Paris. This fixed landing fee is a
traceable cost of the flight, but it is a common cost of the first-class, business-class, and
economy-class segments. Even if the first-class cabin is empty, the entire landing fee
must be paid. So the landing fee is not a traceable cost of the first-class cabin. But on the
other hand, paying the fee is necessary in order to have any first-class, business-class, or
economy-class passengers. So the landing fee is a common cost of these three classes.
245
IN BUSINESS
246
Chapter 6
IN BUSINESS
SEGMENT REPORTING AT THE VILAR PERFORMING ARTS CENTER
The Vilar Performing Arts Center is a 535-seat theater located in Beaver Creek, Colorado, that presents an unusually wide variety of performances categorized into six business segments—Family
Series, Broadway Series, Theatre/Comedy Series, Dance Series, Classical Series, and Concert
Series. The executive director of the Vilar, Kris Sabel, must decide which shows to book, what financial terms to offer to the artists, what contributions are likely from underwriters (i.e., donors), and
what prices to charge for tickets. He evaluates the profitability of the segments using segmented
income statements that include traceable costs (such as the costs of transporting, lodging, and
feeding the artists) and exclude common costs (such as the salaries of Kris and his staff, depreciation on the theater, and general marketing expenses).
Data concerning the Classical Series segment for one season appears below:
Number of shows . . . . . . . . . . . . . . . . . .
Number of seats budgeted . . . . . . . . . .
Number of seats sold . . . . . . . . . . . . . . .
Average seats sold per show . . . . . . . . .
4
863
655
164
Ticket sales . . . . . . . . . . . . . . . . . . . . . .
Underwriting (donors) . . . . . . . . . . . . . . .
$ 46,800
65,000
Total income . . . . . . . . . . . . . . . . . . . . .
Artists fees . . . . . . . . . . . . . . . . . . . . . . .
Other traceable expenses . . . . . . . . . . .
$111,800
78,870
11,231
Classical Series segment margin . . . . .
$ 21,699
Although the Classical Series sold an average of only 164 seats per show, its overall segment margin ($21,699) is positive thanks to $65,000 of underwriting revenues from donors. Had
common costs been allocated to the Classical Series, it may have appeared unprofitable and been
discontinued—resulting in fewer shows during the season; less diverse programming; disappointment among a small, but dedicated, number of fans; and lower overall income for the Vilar due to
the loss of its Classical Series segment margin.
Segmented Income Statements—An Example
ProphetMax, Inc., is a rapidly growing computer software company. Exhibit 6–6 shows
its variable costing income statement for the most recent month. As the company has
grown, its senior managers have asked for segmented income statements that could be
used to make decisions and evaluate managerial performance. ProphetMax’s controller
responded by creating examples of contribution format income statements segmented by
the company’s divisions, product lines, and sales channels. She created Exhibit 6–7 to
explain that ProphetMax’s profits can be segmented into its two divisions—the Business
Products Division and the Consumer Products Division. The Consumer Products Division’s profits can be further segmented into the Clip Art and Computer Games product
lines. Finally, the Computer Games product line’s profits (within the Consumer Products
Division) can be segmented into the Online and Retail Stores sales channels.
Levels of Segmented Income Statements
Exhibit 6–8, on page 248, contains the controller’s segmented income statements for
the segments depicted in Exhibit 6–7. The contribution format income statement for the
entire company appears at the very top of the exhibit under the column labeled Total
Company. Notice, the net operating income shown in this column ($13,500) is the same
as the net operating income shown in Exhibit 6–6. Immediately to the right of the Total
Company column are two columns—one for each of the two divisions. We can see that
the Business Products Division’s traceable fixed expenses are $90,000 and the Consumer
Variable Costing and Segment Reporting: Tools for Management
EXHIBIT 6–6
ProphetMax, Inc. Variable Costing
Income Statement
ProphetMax, Inc.
Variable Costing Income Statement
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses:
Variable cost of goods sold . . . . . . . . . . . . . . . .
Other variable expenses . . . . . . . . . . . . . . . . . . .
Total variable expenses . . . . . . . . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . . . . . . . . . . . . . .
$500,000
180,000
50,000
230,000
270,000
256,500
$ 13,500
EXHIBIT 6–7
ProphetMax, Inc.: Examples of
Business Segments
ProphetMax,
Inc.
Divisions
Business
Products
Division
Product
Lines
Sales
Channels
Consumer
Products
Division
Computer
Games
Online Sales
247
Clip Art
Retail Stores
Products Division’s are $81,000. These $171,000 of traceable fixed expenses (as shown
in the Total Company column) plus the $85,500 of common fixed expenses not traceable
to individual divisions equals ProphetMax’s total fixed expenses ($256,500) as shown
in Exhibit 6–6. We can also see that the Business Products Division’s segment margin is
$60,000 and the Consumer Products Division’s is $39,000. These segment margins show
the company’s divisional managers how much each of their divisions is contributing to
the company’s profits.
The middle portion of Exhibit 6–8 further segments the Consumer Products Division
into its two product lines, Clip Art and Computer Games. The dual nature of some fixed
costs can be seen in this portion of the exhibit. Notice, in the top portion of Exhibit 6–8
when segments are defined as divisions, the Consumer Products Division has $81,000
in traceable fixed expenses. However, when we drill down to the product lines (in the
248
EXHIBIT 6–8
ProphetMax, Inc.—Segmented
Income Statements in the
Contribution Format
Chapter 6
Segments Defined as Divisions
Divisions
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses:
Variable cost of goods sold . . . . . . . . . .
Other variable expenses . . . . . . . . . . . .
Total variable expenses . . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . . . . . . .
Traceable fixed expenses . . . . . . . . . . . . .
Divisional segment margin . . . . . . . . . . . .
Common fixed expenses not
traceable to individual divisions . . . . . . .
Net operating income . . . . . . . . . . . . . . . .
Total
Company
Business
Products
Division
Consumer
Products
Division
$500,000
$300,000
$200,000
180,000
50,000
230,000
270,000
171,000
99,000
120,000
30,000
150,000
150,000
90,000
$ 60,000
60,000
20,000
80,000
120,000
81,000
$ 39,000
85,500
$ 13,500
Segments Defined as Product Lines
of the Consumer Products Division
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses:
Variable cost of goods sold . . . . . . . . . .
Other variable expenses . . . . . . . . . . .
Total variable expenses . . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . . . . . . .
Traceable fixed expenses . . . . . . . . . . . . .
Product-line segment margin . . . . . . . . . .
Common fixed expenses not
traceable to individual product lines . . .
Divisional segment margin . . . . . . . . . . . .
Product Line
Consumer
Products
Division
Clip Art
Computer
Games
$200,000
$75,000
$125,000
60,000
20,000
80,000
120,000
70,000
50,000
20,000
5,000
25,000
50,000
30,000
$20,000
40,000
15,000
55,000
70,000
40,000
$ 30,000
11,000
$ 39,000
Segments Defined as Sales Channels for One Product Line,
Computer Games, of the Consumer Products Division
Sales Channels
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses:
Variable cost of goods sold . . . . . . . . . .
Other variable expenses . . . . . . . . . . . .
Total variable expenses . . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . . . . . . .
Traceable fixed expenses . . . . . . . . . . . . .
Sales-channel segment margin . . . . . . . . .
Common fixed expenses not
traceable to individual sales channels . . .
Product-line segment margin . . . . . . . . . .
Computer
Games
Online
Sales
Retail
Stores
$125,000
$100,000
$25,000
40,000
15,000
55,000
70,000
25,000
45,000
32,000
5,000
37,000
63,000
15,000
$ 48,000
8,000
10,000
18,000
7,000
10,000
$ (3,000)
15,000
$ 30,000
Variable Costing and Segment Reporting: Tools for Management
middle portion of the exhibit), only $70,000 of the $81,000 cost that was traceable to the
Consumer Products Division is traceable to the product lines. The other $11,000 becomes
a common fixed cost of the two product lines of the Consumer Products Division.
Why would $11,000 of traceable fixed costs become a common fixed cost when the
division is divided into product lines? The $11,000 is the monthly depreciation expense
on a machine that is used to encase products in tamper-proof packages for the consumer
market. The depreciation expense is a traceable cost of the Consumer Products Division
as a whole, but it is a common cost of the division’s two product lines. Even if one of
the product lines were discontinued entirely, the machine would still be used to wrap the
remaining products. Therefore, none of the depreciation expense can really be traced to
individual products. Conversely, the $70,000 traceable fixed cost can be traced to the
individual product lines because it consists of the costs of product-specific advertising. A
total of $30,000 was spent on advertising clip art and $40,000 was spent on advertising
computer programs.
The bottom portion of Exhibit 6–8 further segments the Computer Games product
line into two sales channels, Online Sales and Retail Stores. The dual nature of some
fixed costs can also be seen in this portion of the exhibit. In the middle portion of
Exhibit 6–8 when segments are defined as product lines, the Computer Games product
line has $40,000 in traceable fixed expenses. However, when we look at the sales channels in the bottom portion of the exhibit, only $25,000 of the $40,000 that was traceable
to Computer Games is traceable to the sales channels. The other $15,000 becomes a common fixed cost of the two sales channels for the Computer Games product line.
Segmented Income Statements—Decision Making and Break-Even Analysis
Once a company prepares contribution format segmented income statements, it can use
those statements to make decisions and perform break-even analysis.
Decision Making
Let’s refer again to the bottom portion of Exhibit 6–8 to illustrate how segmented income
statements support decision making. Notice that the Online Sales segment has a segment
margin of $48,000 and the Retail Stores segment has a segment margin of $(3,000). Let’s
assume that ProphetMax wants to know the profit impact of discontinuing the sale of
computer games through its Retail Stores sales channel. The company believes that online
sales of its computer games will increase 10% if it discontinues the Retail Stores sales
channel. It also believes that the Business Products Division and Clip Art product line will
be unaffected by this decision. How would you compute the profit impact of this decision?
The first step is to calculate the profit impact of the Retail Stores sales channel
disappearing. If this sales channel disappears, we assume its sales, variable expenses,
and traceable fixed expenses would all disappear. The quickest way to summarize these
financial impacts is to focus on the Retail Stores’ segment margin. In other words, if
the Retail Stores sales channel disappears, then its negative segment margin of $3,000
would also disappear. This would increase ProphetMax’s net operating income by
$3,000. The second step is to calculate the profit impact of increasing online sales of
computer games by 10%. To perform this calculation, we assume that the Online Sales
total traceable fixed expenses ($15,000) remain constant and its contribution margin
ratio remains constant at 63% (5 $63,000 4 $100,000). If online sales increase $10,000
(5 $100,000 3 10%), then the Online Sales segment’s contribution margin will increase
by $6,300 (5 $10,000 3 63%). The overall profit impact of discontinuing the Retail
Stores sales channel can be summarized as follows:
Avoidance of the retail segment’s loss . . . . . . . . . . . . . . .
Online Sales additional contribution margin . . . . . . . . . . .
Increase in ProphetMax’s net operating income . . . . . . . .
$3,000
6,300
$9,300
249
250
LO6–5
Compute companywide and
segment break-even points for
a company with traceable fixed
costs.
Chapter 6
Break-Even Analysis
In Chapter 5, we learned how to compute a companywide break-even point for a multiproduct company with no traceable fixed expenses. Now we are going to use the ProphetMax, Inc., data in Exhibit 6–8 to explain how to compute companywide and segment
break-even points for a company with traceable fixed expenses. The formula for computing a companywide break-even point is as follows:
Dollar sales for company ___________________________________________
Traceable fixed expenses 1 Common fixed expenses
5
to break even
Overall CM ratio
In the case of ProphetMax, we should begin by reviewing the information in the
Total Company column in the top portion of Exhibit 6–8. This column of data indicates
that ProphetMax’s total traceable fixed expenses are $171,000 and its total common
fixed expenses are $85,500. Furthermore, the company’s overall contribution margin of
$270,000 divided by its total sales of $500,000 equals its overall CM ratio of 0.54. Given
this information, ProphetMax’s companywide break-even point is computed as follows:
Dollar sales for company ___________________________________________
Traceable fixed expenses 1 Common fixed expenses
5
to break even
Overall CM ratio
$171,000
1
$85,500
5 _________________
0.54
$256,500
5 ________
0.54
5 $475,000
It is important to emphasize that this computation assumes a constant sales mix. In other
words, in the ProphetMax example, it assumes that 60% of the total sales ($300,000 4
$500,000) will always come from the Business Products Division and 40% of the total
sales ($200,000 4 $500,000) will always come from the Consumer Products Division.
To compute the break-even point for a business segment, the formula is as follows:
Dollar sales for a segment ____________________________
Segment traceable fixed expenses
5
to break even
Segment CM ratio
In the case of ProphetMax’s Business Products Division, we should begin by reviewing the information in the Business Products Division column in the top portion of
Exhibit 6–8. This column of data indicates that the Business Products Division’s traceable
fixed expenses are $90,000 and its CM ratio is 0.50 ($150,000 4 $300,000). Given this
information, the Business Products Division’s break-even point is computed as follows:
Segment traceable fixed expenses
Dollar sales for a segment ____________________________
5
to break even
Segment CM ratio
$90,000
5 _______
0.50
5 $180,000
The same calculation can be performed for the Consumer Products Division using data
from the Consumer Products Division column in the top portion of Exhibit 6–8. Given
that the Consumer Products Division’s traceable fixed expenses are $81,000 and its CM
ratio is 0.60 ($120,000 4 $200,000), its break-even point is computed as follows:
Segment traceable fixed expenses
Dollar sales for a segment ____________________________
5
to break even
Segment CM ratio
$81,000
5 _______
0.60
5 $135,000
Variable Costing and Segment Reporting: Tools for Management
Notice that the sum of the segment break-even sales figures of $315,000 ($180,000 1
$135,000) is less than the companywide break-even point of $475,000. This occurs
because the segment break-even calculations do not include the company’s common fixed
expenses. The exclusion of the company’s common fixed expenses can be verified by
preparing income statements based on each segment’s break-even dollar sales as follows:
Total
Company
Sales . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . . .
Traceable fixed expenses . . . . . . . . .
Segment margin . . . . . . . . . . . . . . . .
Common fixed expenses . . . . . . . . .
Net operating loss . . . . . . . . . . . . . . .
$315,000
144,000
171,000
171,000
0
85,500
$ (85,500)
Business
Products
Division
Consumer
Products
Division
$180,000
90,000
90,000
90,000
$
0
$135,000
54,000
81,000
81,000
$
0
When each segment achieves its break-even point, the company’s overall net operating
loss of $85,500 equals its common fixed expenses of $85,500. This reality can often lead
managers astray when making decisions. In an attempt to “cover the company’s common
fixed expenses,” managers will often allocate common fixed expenses to business segments when performing break-even calculations and making decisions. This is a mistake!
Allocating common fixed expenses to business segments artificially inflates each segment’s break-even point. This may cause managers to erroneously discontinue business
segments where the inflated break-even point appears unobtainable. The decision to
retain or discontinue a business segment should be based on the sales and expenses that
would disappear if the segment were dropped. Because common fixed expenses will persist even if a business segment is dropped, they should not be allocated to business segments when making decisions.
Segmented Income Statements—Common Mistakes
All of the costs attributable to a segment—and only those costs—should be assigned to
the segment. Unfortunately, companies often make mistakes when assigning costs to segments. They omit some costs, inappropriately assign traceable fixed costs, and arbitrarily
allocate common fixed costs.
Omission of Costs
The costs assigned to a segment should include all costs attributable to that segment from
the company’s entire value chain. All of these functions, from research and development,
through product design, manufacturing, marketing, distribution, and customer service,
are required to bring a product or service to the customer and generate revenues.
However, only manufacturing costs are included in product costs under absorption
costing, which is widely regarded as required for external financial reporting. To avoid
having to maintain two costing systems and to provide consistency between internal and
external reports, many companies also use absorption costing for their internal reports
such as segmented income statements. As a result, such companies omit from their profitability analysis part or all of the “upstream” costs in the value chain, which consist
of research and development and product design, and the “downstream” costs, which
consist of marketing, distribution, and customer service. Yet these nonmanufacturing
costs are just as essential in determining product profitability as are the manufacturing
costs. These upstream and downstream costs, which are usually included in selling and
251
252
Chapter 6
administrative expenses on absorption costing income statements, can represent half or
more of the total costs of an organization. If either the upstream or downstream costs are
omitted in profitability analysis, then the product is undercosted and management may
unwittingly develop and maintain products that in the long run result in losses.
Inappropriate Methods for Assigning Traceable Costs
among Segments
In addition to omitting costs, many companies do not correctly handle traceable fixed
expenses on segmented income statements. First, they do not trace fixed expenses to segments even when it is feasible to do so. Second, they use inappropriate allocation bases to
allocate traceable fixed expenses to segments.
Failure to Trace Costs Directly Costs that can be traced directly to a specific
segment should be charged directly to that segment and should not be allocated to other
segments. For example, the rent for a branch office of an insurance company should be
charged directly to the branch office rather than included in a companywide overhead
pool and then spread throughout the company.
Inappropriate Allocation Base Some companies use arbitrary allocation bases
to allocate costs to segments. For example, some companies allocate selling and administrative expenses on the basis of sales revenues. Thus, if a segment generates 20% of total
company sales, it would be allocated 20% of the company’s selling and administrative
expenses as its “fair share.” This same basic procedure is followed if cost of goods sold or
some other measure is used as the allocation base.
Costs should be allocated to segments for internal decision-making purposes only
when the allocation base actually drives the cost being allocated (or is very highly correlated with the real cost driver). For example, sales should be used to allocate selling and
administrative expenses only if a 10% increase in sales will result in a 10% increase in
selling and administrative expenses. To the extent that selling and administrative expenses
are not driven by sales volume, these expenses will be improperly allocated—with a disproportionately high percentage of the selling and administrative expenses assigned to
the segments with the largest sales.
Arbitrarily Dividing Common Costs among Segments
The third business practice that leads to distorted segment costs is the practice of assigning nontraceable costs to segments. For example, some companies allocate the common
costs of the corporate headquarters building to products on segment reports. However, in
a multiproduct company, no single product is likely to be responsible for any significant
amount of this cost. Even if a product were eliminated entirely, there would usually be
no significant effect on any of the costs of the corporate headquarters building. In short,
there is no cause-and-effect relation between the cost of the corporate headquarters building and the existence of any one product. As a consequence, any allocation of the cost of
the corporate headquarters building to the products must be arbitrary.
Common costs like the costs of the corporate headquarters building are necessary, of
course, to have a functioning organization. The practice of arbitrarily allocating common
costs to segments is often justified on the grounds that “someone” has to “cover the common costs.” While it is undeniably true that a company must cover its common costs to
earn a profit, arbitrarily allocating common costs to segments does not ensure that this will
happen. In fact, adding a share of common costs to the real costs of a segment may make an
otherwise profitable segment appear to be unprofitable. If a manager eliminates the apparently unprofitable segment, the real traceable costs of the segment will be saved, but its
revenues will be lost. And what happens to the common fixed costs that were allocated to
the segment? They don’t disappear; they are reallocated to the remaining segments of the
company. That makes all of the remaining segments appear to be less profitable—possibly
Variable Costing and Segment Reporting: Tools for Management
resulting in dropping other segments. The net effect will be to reduce the overall profits of
the company and make it even more difficult to “cover the common costs.”
Additionally, common fixed costs are not manageable by the manager to whom they
are arbitrarily allocated; they are the responsibility of higher-level managers. When common fixed costs are allocated to managers, they are held responsible for those costs even
though they cannot control them.
Income Statements—An External Reporting Perspective
Companywide Income Statements
Practically speaking, absorption costing is required for external reports according to U.S.
generally accepted accounting principles (GAAP).3 Furthermore, International Financial Reporting Standards (IFRS) explicitly require companies to use absorption costing.
Probably because of the cost and possible confusion of maintaining two separate costing
systems—one for external reporting and one for internal reporting—most companies use
absorption costing for their external and internal reports.
With all of the advantages of the contribution approach, you may wonder why the
absorption approach is used at all. While the answer is partly due to adhering to tradition, absorption costing is also attractive to many accountants and managers because they
believe it better matches costs with revenues. Advocates of absorption costing argue that
all manufacturing costs must be assigned to products in order to properly match the costs
of producing units of product with their revenues when they are sold. The fixed costs
of depreciation, taxes, insurance, supervisory salaries, and so on, are just as essential to
manufacturing products as are the variable costs.
Advocates of variable costing argue that fixed manufacturing costs are not really the
costs of any particular unit of product. These costs are incurred to have the capacity to
make products during a particular period and will be incurred even if nothing is made during the period. Moreover, whether a unit is made or not, the fixed manufacturing costs will
be exactly the same. Therefore, variable costing advocates argue that fixed manufacturing
costs are not part of the costs of producing a particular unit of product, and thus, the matching principle dictates that fixed manufacturing costs should be charged to the current period.
Segmented Financial Information
U.S. GAAP and IFRS require that publicly traded companies include segmented financial and other data in their annual reports and that the segmented reports prepared for
external users must use the same methods and definitions that the companies use in internal segmented reports that are prepared to aid in making operating decisions. This is a
very unusual stipulation because companies are not ordinarily required to report the same
data to external users that are used for internal decision-making purposes. This requirement creates incentives for publicly traded companies to avoid using the contribution
format for internal segmented reports. Segmented contribution format income statements
contain vital information that companies are often very reluctant to release to the public
(and hence competitors). In addition, this requirement creates problems in reconciling
internal and external reports.
3
The Financial Accounting Standards Board (FASB) has created a single source of authoritative nongovernmental U.S. generally accepted accounting principles (GAAP) called the FASB Accounting Standards Codification (FASB codification). Although the FASB codification does not explicitly disallow
variable costing, it does explicitly prohibit companies from excluding all manufacturing overhead costs
from product costs. It also provides an in-depth discussion of fixed overhead allocation to products,
thereby implying that absorption costing is required for external reports. Although some companies
expense significant elements of fixed manufacturing costs on their external reports, practically speaking,
U.S. GAAP requires absorption costing for external reports.
253
254
Chapter 6
IN BUSINESS
3M REPORTS SEGMENTED PROFITABILITY TO SHAREHOLDERS
In 2009, 3M Company reported segmented profitability to its shareholders by product lines and
geographic areas. A portion of the company’s segmented information is summarized below (all
numbers are in millions):
Net Sales
Net Operating
Income
Product Lines:
Industrial and transportation . . . . . . . . . . . . . . . . . .
Health care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consumer and office . . . . . . . . . . . . . . . . . . . . . . . .
Safety, security, and protection services . . . . . . . . .
Display and graphics . . . . . . . . . . . . . . . . . . . . . . . .
Electro and communications . . . . . . . . . . . . . . . . . .
$7,116
$4,294
$3,471
$3,180
$3,132
$2,276
$1,238
$1,350
$748
$745
$590
$322
Geographic Areas:
United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Asia Pacific . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Europe, Middle East and Africa . . . . . . . . . . . . . . . .
Latin America and Canada . . . . . . . . . . . . . . . . . . . .
$8,509
$6,120
$5,972
$2,516
$1,640
$1,528
$1,003
$631
3M’s annual report does not report the gross margins or contribution margins for its business
segments. Why do you think this is the case?
Source: 3M Company, 2009 Annual Report.
Summary
Variable and absorption costing are alternative methods of determining unit product costs. Under
variable costing, only those manufacturing costs that vary with output are treated as product costs.
This includes direct materials, variable overhead, and ordinarily direct labor. Fixed manufacturing
overhead is treated as a period cost and it is expensed on the income statement as incurred. By contrast, absorption costing treats fixed manufacturing overhead as a product cost, along with direct
materials, direct labor, and variable overhead. Under both costing methods, selling and administrative expenses are treated as period costs and they are expensed on the income statement as
incurred.
Because absorption costing treats fixed manufacturing overhead as a product cost, a portion
of fixed manufacturing overhead is assigned to each unit as it is produced. If units of product are
unsold at the end of a period, then the fixed manufacturing overhead cost attached to those units is
carried with them into the inventory account and deferred to a future period. When these units are
later sold, the fixed manufacturing overhead cost attached to them is released from the inventory
account and charged against income as part of cost of goods sold. Thus, under absorption costing, it is possible to defer a portion of the fixed manufacturing overhead cost from one period to a
future period through the inventory account.
Unfortunately, this shifting of fixed manufacturing overhead cost between periods can cause
erratic fluctuations in net operating income and can result in confusion and unwise decisions. To
guard against mistakes when they interpret income statement data, managers should be alert to
changes in inventory levels or unit product costs during the period.
Segmented income statements provide information for evaluating the profitability and performance of divisions, product lines, sales territories, and other segments of a company. Under the
contribution approach, variable costs and fixed costs are clearly distinguished from each other and
only those costs that are traceable to a segment are assigned to the segment. A cost is considered
Variable Costing and Segment Reporting: Tools for Management
traceable to a segment only if the cost is caused by the segment and could be avoided by eliminating the segment. Fixed common costs are not allocated to segments. The segment margin consists
of revenues, less variable expenses, less traceable fixed expenses of the segment.
The dollar sales required for a segment to break even is computed by dividing the segment’s
traceable fixed expenses by its contribution margin ratio. A company’s common fixed expenses
should not be allocated to segments when performing break-even calculations because they will
not change in response to segment-level decisions.
Review Problem 1: Contrasting Variable and Absorption Costing
Dexter Corporation produces and sells a single product, a wooden hand loom for weaving small
items such as scarves. Selected cost and operating data relating to the product for two years are
given below:
Selling price per unit . . . . . . . . . . . . . . . . . . . . . .
Manufacturing costs:
Variable per unit produced:
Direct materials . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . .
Fixed manufacturing overhead per year . . . . . .
Selling and administrative expenses:
Variable per unit sold . . . . . . . . . . . . . . . . . . . .
Fixed per year . . . . . . . . . . . . . . . . . . . . . . . . .
Units in beginning inventory . . . . . . . . . . .
Units produced during the year . . . . . . . .
Units sold during the year . . . . . . . . . . . .
Units in ending inventory . . . . . . . . . . . . .
$50
$11
$6
$3
$120,000
$4
$70,000
Year 1
Year 2
0
10,000
8,000
2,000
2,000
6,000
8,000
0
Required:
1.
2.
3.
Assume the company uses absorption costing.
a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.
Assume the company uses variable costing.
a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.
Reconcile the variable costing and absorption costing net operating incomes.
Solution to Review Problem 1
1.
a.
Under absorption costing, all manufacturing costs, variable and fixed, are included in
unit product costs:
Year 1
Direct materials . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . .
Fixed manufacturing overhead
($120,000 4 10,000 units) . . . . . . . . . . . . .
($120,000 4 6,000 units) . . . . . . . . . . . . . .
$11
6
3
Absorption costing unit product cost . . . . . . .
$32
Year 2
$11
6
3
12
20
$40
255
256
Chapter 6
b.
2.
The absorption costing income statements follow:
Year 1
Year 2
Sales (8,000 units 3 $50 per unit) . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold (8,000 units 3 $32 per unit);
(2,000 units 3 $32 per unit) 1
(6,000 units 3 $40 per unit) . . . . . . . . . . . . . . . . . . . . . . . .
$400,000
$400,000
256,000
304,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses
(8,000 units 3 $4 per unit 1 $70,000) . . . . . . . . . . . . . . . .
144,000
96,000
102,000
102,000
Net operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 42,000
$ (6,000)
a.
b.
Under variable costing, only the variable manufacturing costs are included in unit product costs:
Year 1
Year 2
Direct materials . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . .
$11
6
3
$11
6
3
Variable costing unit product cost . . . . . . . . .
$20
$20
The variable costing income statements follow:
Year 1
Sales (8,000 units 3 $50 per unit) . . . . . . . . .
Variable expenses:
Variable cost of goods sold
(8,000 units 3 $20 per unit) . . . . . . . . . .
Variable selling and administrative
expenses (8,000 units 3 $4 per unit) . . .
Contribution margin . . . . . . . . . . . . . . . . . . .
Fixed expenses:
Fixed manufacturing overhead . . . . . . . . . .
Fixed selling and administrative
expenses . . . . . . . . . . . . . . . . . . . . . . . .
Net operating income . . . . . . . . . . . . . . . . . .
3.
Year 2
$400,000
$160,000
32,000
$400,000
$160,000
192,000
32,000
208,000
120,000
70,000
192,000
208,000
120,000
190,000
70,000
$ 18,000
190,000
$ 18,000
The reconciliation of the variable and absorption costing net operating incomes follows:
Year 1
Year 2
Fixed manufacturing overhead in ending inventories . . . . .
Fixed manufacturing overhead in beginning inventories . . .
$24,000
0
$
0
24,000
Fixed manufacturing overhead deferred in
(released from) inventories . . . . . . . . . . . . . . . . . . . . . . . .
$24,000
$(24,000)
Year 1
Year 2
Variable costing net operating income . . . . . . . . . . . . . . . . . .
Add fixed manufacturing overhead costs deferred
in inventory under absorption costing
(2,000 units 3 $12 per unit) . . . . . . . . . . . . . . . . . . . . . . . .
Deduct fixed manufacturing overhead costs released
from inventory under absorption costing
(2,000 units 3 $12 per unit) . . . . . . . . . . . . . . . . . . . . . . . .
$18,000
$18,000
Absorption costing net operating income (loss) . . . . . . . . . . .
$42,000
24,000
(24,000)
$ (6,000)
Variable Costing and Segment Reporting: Tools for Management
Review Problem 2: Segmented Income Statements
The business staff of the law firm Frampton, Davis & Smythe has constructed the following report
that breaks down the firm’s overall results for last month into two business segments—family law
and commercial law:
Company
Total
Family
Law
Commercial
Law
Revenues from clients . . . . . . . . .
Variable expenses . . . . . . . . . . . .
$1,000,000
220,000
$400,000
100,000
$600,000
120,000
Contribution margin . . . . . . . . . . .
Traceable fixed expenses . . . . . . .
780,000
670,000
300,000
280,000
480,000
390,000
Segment margin . . . . . . . . . . . . .
Common fixed expenses . . . . . .
110,000
60,000
20,000
24,000
90,000
36,000
50,000
$ (4,000)
$ 54,000
Net operating income (loss) . . . . .
$
However, this report is not quite correct. The common fixed expenses such as the managing partner’s salary, general administrative expenses, and general firm advertising have been allocated to
the two segments based on revenues from clients.
Required:
1.
2.
3.
Redo the segment report, eliminating the allocation of common fixed expenses. Would the
firm be better off financially if the family law segment were dropped? (Note: Many of the
firm’s commercial law clients also use the firm for their family law requirements such as
drawing up wills.)
The firm’s advertising agency has proposed an ad campaign targeted at boosting the revenues
of the family law segment. The ad campaign would cost $20,000, and the advertising agency
claims that it would increase family law revenues by $100,000. The managing partner of
Frampton, Davis & Smythe believes this increase in business could be accommodated without
any increase in fixed expenses. Estimate the effect this ad campaign would have on the family
law segment margin and on the firm’s overall net operating income.
Compute the companywide break-even point in dollar sales and the dollar sales required for
each business segment to break even.
Solution to Review Problem 2
1.
The corrected segmented income statement appears below:
Company
Total
Family
Law
Commercial
Law
Revenues from clients . . . . . . . . .
Variable expenses . . . . . . . . . . . .
$1,000,000
220,000
$400,000
100,000
$600,000
120,000
Contribution margin . . . . . . . . . . .
Traceable fixed expenses . . . . . . .
780,000
670,000
300,000
280,000
480,000
390,000
Segment margin . . . . . . . . . . . . .
110,000
$ 20,000
$ 90,000
Common fixed expenses . . . . . .
60,000
Net operating income . . . . . . . . . .
$
50,000
No, the firm would not be financially better off if the family law practice were dropped. The
family law segment is covering all of its own costs and is contributing $20,000 per month to
covering the common fixed expenses of the firm. While the segment margin for family law
257
258
Chapter 6
2.
is much lower than for commercial law, it is still profitable. Moreover, family law may be a
service that the firm must provide to its commercial clients in order to remain competitive.
The ad campaign would increase the family law segment margin by $55,000 as follows:
Increased revenues from clients . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Family law contribution margin ratio ($300,000 4 $400,000) . . . . . . .
$100,000
3 75%
Increased contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less cost of the ad campaign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 75,000
20,000
Increased segment margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 55,000
Because there would be no increase in fixed expenses (including common fixed expenses), the
increase in overall net operating income is also $55,000.
3.
The companywide break-even point is computed as follows:
Dollar sales for company ___________________________________________
Traceable fixed expenses 1 Common fixed expenses
5
to break even
Overall CM ratio
$670,000 1 $60,000
5 _________________
0.78
$730,000
5 ________
0.78
5 $935,897 (rounded)
The break-even point for the family law segment is computed as follows:
Segment traceable fixed expenses
Dollar sales for a segment ____________________________
5
to break even
Segment CM ratio
$280,000
5 ________
0.75
5 $373,333 (rounded)
The break-even point for the commercial law segment is computed as follows:
Segment traceable fixed expenses
Dollar sales for a segment ____________________________
5
to break even
Segment CM ratio
$390,000
5 ________
0.80
5 $487,500
Glossary
Absorption costing A costing method that includes all manufacturing costs—direct materials, direct labor, and both variable and fixed manufacturing overhead—in unit product
costs. (p. 234)
Common fixed cost A fixed cost that supports more than one business segment, but is not traceable in whole or in part to any one of the business segments. (p. 244)
Variable Costing and Segment Reporting: Tools for Management
259
Segment Any part or activity of an organization about which managers seek cost, revenue, or
profit data. (p. 234)
Segment margin A segment’s contribution margin less its traceable fixed costs. It represents the
margin available after a segment has covered all of its own traceable costs. (p. 244)
Traceable fixed cost A fixed cost that is incurred because of the existence of a particular business
segment and that would be eliminated if the segment were eliminated. (p. 244)
Variable costing A costing method that includes only variable manufacturing costs—direct materials, direct labor, and variable manufacturing overhead—in unit product costs. (p. 234)
Questions
6–1
6–2
6–3
6–4
6–5
6–6
6–7
6–8
6–9
6–10
6–11
6–12
6–13
6–14
6–15
6–16
6–17
What is the basic difference between absorption costing and variable costing?
Are selling and administrative expenses treated as product costs or as period costs under
variable costing?
Explain how fixed manufacturing overhead costs are shifted from one period to another
under absorption costing.
What are the arguments in favor of treating fixed manufacturing overhead costs as
product costs?
What are the arguments in favor of treating fixed manufacturing overhead costs as
period costs?
If the units produced and unit sales are equal, which method would you expect to show
the higher net operating income, variable costing or absorption costing? Why?
If the units produced exceed unit sales, which method would you expect to show the
higher net operating income, variable costing or absorption costing? Why?
If fixed manufacturing overhead costs are released from inventory under absorption
costing, what does this tell you about the level of production in relation to the level
of sales?
Under absorption costing, how is it possible to increase net operating income without
increasing sales?
How does Lean Production reduce or eliminate the difference in reported net operating
income between absorption and variable costing?
What is a segment of an organization? Give several examples of segments.
What costs are assigned to a segment under the contribution approach?
Distinguish between a traceable cost and a common cost. Give several examples
of each.
Explain how the segment margin differs from the contribution margin.
Why aren’t common costs allocated to segments under the contribution approach?
How is it possible for a cost that is traceable to a segment to become a common cost if
the segment is divided into further segments?
Should a company allocate its common fixed expenses to business segments when computing the break-even point for those segments? Why?
Multiple-choice questions are provided on the text website at www.mhhe.com/garrison15e.
Applying Excel
Available with McGraw-Hill’s Connect® Accounting.
The Excel worksheet form that appears on the next page is to be used to recreate portions of Review
Problem 1 on pages 255–256. Download the workbook containing this form from the Online
Learning Center at www.mhhe.com/garrison15e. On the website you will also receive instructions about how to use this worksheet form.
LO6–2
260
Chapter 6
You should proceed to the requirements below only after completing your worksheet. The
LIFO inventory flow assumption is used throughout this problem.
Required:
1.
Check your worksheet by changing the units sold in the Data to 6,000 for Year 2. The cost of
goods sold under absorption costing for Year 2 should now be $240,000. If it isn’t, check cell
C41. The formula in this cell should be 5IF(C26,C27,C26*C361(C27-C26)*B36,C27*C36).
If your worksheet is operating properly, the net operating income under both absorption costing and variable costing should be $(34,000) for Year 2. That is, the loss in Year 2 is $34,000
under both systems. If you do not get these answers, find the errors in your worksheet and
correct them.
Why is the absorption costing net operating income now equal to the variable costing net
operating income in Year 2?
Variable Costing and Segment Reporting: Tools for Management
2.
261
Enter the following data from a different company into your worksheet:
Data
Selling price per unit . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing costs:
Variable per unit produced:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . .
Fixed manufacturing overhead per year . . . . . .
Selling and administrative expenses:
Variable per unit sold . . . . . . . . . . . . . . . . . . . . .
Fixed per year . . . . . . . . . . . . . . . . . . . . . . . . . .
Units in beginning inventory . . . . . . . . . . . . . . . . . .
Units produced during the year . . . . . . . . . . . . . . .
Units sold during the year . . . . . . . . . . . . . . . . . . .
3.
$75
$12
$5
$7
$150,000
$1
$60,000
Year 1
Year 2
0
15,000
12,000
10,000
12,000
Is the net operating income under variable costing different in Year 1 and Year 2? Why or why
not? Explain the relation between the net operating income under absorption costing and variable costing in Year 1. Explain the relation between the net operating income under absorption
costing and variable costing in Year 2.
At the end of Year 1, the company’s board of directors set a target for Year 2 of net operating income of $500,000 under absorption costing. If this target is met, a hefty bonus would
be paid to the CEO of the company. Keeping everything else the same from part (2) above,
change the units produced in Year 2 to 50,000 units. Would this change result in a bonus being
paid to the CEO? Do you think this change would be in the best interests of the company?
What is likely to happen in Year 3 to the absorption costing net operating income if sales
remain constant at 12,000 units per year?
The Foundational 15
Available with McGraw-Hill’s Connect® Accounting.
Diego Company manufactures one product that is sold for $80 per unit in two geographic regions—
the East and West regions. The following information pertains to the company’s first year of operations in which it produced 40,000 units and sold 35,000 units.
Variable costs per unit:
Manufacturing:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . .
Variable selling and administrative . . . . . . . . . . . . . . . .
Fixed costs per year:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . . .
$24
$14
$2
$4
$800,000
$496,000
The company sold 25,000 units in the East region and 10,000 units in the West region. It determined that $250,000 of its fixed selling and administrative expenses is traceable to the West region,
$150,000 is traceable to the East region, and the remaining $96,000 is a common fixed cost. The
company will continue to incur the total amount of its fixed manufacturing overhead costs as long
as it continues to produce any amount of its only product.
LO6–1, LO6–2, LO6–3,
LO6–4
262
Chapter 6
Required:
Answer each question independently based on the original data unless instructed otherwise. You do
not need to prepare a segmented income statement until question 13.
1. What is the unit product cost under variable costing?
2. What is the unit product cost under absorption costing?
3. What is the company’s total contribution margin under variable costing?
4. What is the company’s net operating income under variable costing?
5. What is the company’s total gross margin under absorption costing?
6. What is the company’s net operating income under absorption costing?
7. What is the amount of the difference between the variable costing and absorption costing net
operating incomes? What is the cause of this difference?
8. What is the company’s break-even point in unit sales? Is it above or below the actual sales
volume? Compare the break-even sales volume to your answer for question 6 and comment.
9. If the sales volumes in the East and West regions had been reversed, what would be the company’s overall break-even point in unit sales?
10. What would have been the company’s variable costing net operating income if it had produced
and sold 35,000 units? You do not need to perform any calculations to answer this question.
11. What would have been the company’s absorption costing net operating income if it had
produced and sold 35,000 units? You do not need to perform any calculations to answer this
question.
12. If the company produces 5,000 fewer units than it sells in its second year of operations, will
absorption costing net operating income be higher or lower than variable costing net operating income in Year 2? Why? No calculations are necessary.
13. Prepare a contribution format segmented income statement that includes a Total column and
columns for the East and West regions.
14. Diego is considering eliminating the West region because an internally generated report suggests the region’s total gross margin in the first year of operations was $50,000 less than its
traceable fixed selling and administrative expenses. Diego believes that if it drops the West
region, the East region’s sales will grow by 5% in Year 2. Using the contribution approach
for analyzing segment profitability and assuming all else remains constant in Year 2, what
would be the profit impact of dropping the West region in Year 2?
15. Assume the West region invests $30,000 in a new advertising campaign in Year 2 that
increases its unit sales by 20%. If all else remains constant, what would be the profit impact
of pursuing the advertising campaign?
Exercises
All applicable exercises are available with McGraw-Hill’s Connect® Accounting.
EXERCISE 6–1 Variable and Absorption Costing Unit Product Costs [LO6–1]
Ida Sidha Karya Company is a family-owned company located in the village of Gianyar on the
island of Bali in Indonesia. The company produces a handcrafted Balinese musical instrument
called a gamelan that is similar to a xylophone. The gamelans are sold for $850. Selected data for
the company’s operations last year follow:
Units in beginning inventory . . . . . . . . . . . . . . . . . . . .
Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units in ending inventory . . . . . . . . . . . . . . . . . . . . . . .
Variable costs per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . .
Variable selling and administrative . . . . . . . . . . . . . .
Fixed costs:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . .
Fixed selling and administrative . . . . . . . . . . . . . . . .
0
250
225
25
$100
$320
$40
$20
$60,000
$20,000
Variable Costing and Segment Reporting: Tools for Management
Required:
1.
2.
Assume that the company uses absorption costing. Compute the unit product cost for one
gamelan.
Assume that the company uses variable costing. Compute the unit product cost for one
gamelan.
EXERCISE 6–2 Variable Costing Income Statement; Explanation of Difference in Net Operating
Income [LO6–2]
Refer to the data in Exercise 6–1 for Ida Sidha Karya Company. The absorption costing income
statement prepared by the company’s accountant for last year appears below:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . .
$191,250
157,500
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expense . . . . . . . . . . . . . .
33,750
24,500
$
Net operating income . . . . . . . . . . . . . . . . . . . . . . . . .
9,250
Required:
1.
2.
Determine how much of the ending inventory consists of fixed manufacturing overhead cost
deferred in inventory to the next period.
Prepare an income statement for the year using variable costing. Explain the difference in net
operating income between the two costing methods.
EXERCISE 6–3 Reconciliation of Absorption and Variable Costing Net Operating Incomes [LO6–3]
Jorgansen Lighting, Inc., manufactures heavy-duty street lighting systems for municipalities. The
company uses variable costing for internal management reports and absorption costing for external
reports to shareholders, creditors, and the government. The company has provided the following data:
Inventories:
Beginning (units) . . . . . . . . . . . . . . . . . . . . .
Ending (units) . . . . . . . . . . . . . . . . . . . . . . .
Variable costing net operating income . . . . . .
Year 1
Year 2
Year 3
200
170
$1,080,400
170
180
$1,032,400
180
220
$996,400
The company’s fixed manufacturing overhead per unit was constant at $560 for all three years.
Required:
1.
2.
Determine each year’s absorption costing net operating income. Present your answer in the
form of a reconciliation report.
In Year 4, the company’s variable costing net operating income was $984,400 and its absorption costing net operating income was $1,012,400. Did inventories increase or decrease during Year 4? How much fixed manufacturing overhead cost was deferred or released from
inventory during Year 4?
EXERCISE 6–4 Basic Segmented Income Statement [LO6–4]
Royal Lawncare Company produces and sells two packaged products, Weedban and Greengrow.
Revenue and cost information relating to the products follow:
Product
Selling price per unit . . . . . . . . . . . . . . . . . . . . . .
Variable expenses per unit . . . . . . . . . . . . . . . . .
Traceable fixed expenses per year . . . . . . . . . . .
Weedban
Greengrow
$6.00
$2.40
$45,000
$7.50
$5.25
$21,000
Common fixed expenses in the company total $33,000 annually. Last year the company produced
and sold 15,000 units of Weedban and 28,000 units of Greengrow.
Required:
Prepare a contribution format income statement segmented by product lines.
263
264
Chapter 6
EXERCISE 6–5 Companywide and Segment Break-Even Analysis [LO6–5]
Piedmont Company segments its business into two regions—North and South. The company prepared the contribution format segmented income statement shown below:
Total
Company
North
South
Sales . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . .
$600,000
360,000
$400,000
280,000
$200,000
80,000
Contribution margin . . . . . . . . . . . . . .
Traceable fixed expenses . . . . . . . . . .
240,000
120,000
120,000
60,000
120,000
60,000
Segment margin . . . . . . . . . . . . . . . . .
Common fixed expenses . . . . . . . . .
120,000
50,000
$ 60,000
$ 60,000
Net operating income . . . . . . . . . . . . .
$ 70,000
Required:
1.
2.
3.
Compute the companywide break-even point in dollar sales.
Compute the break-even point in dollar sales for the North region.
Compute the break-even point in dollar sales for the South region.
EXERCISE 6–6 Variable and Absorption Costing Unit Product Costs and Income Statements
[LO6–1, LO6–2]
Lynch Company manufactures and sells a single product. The following costs were incurred
during the company’s first year of operations:
Variable costs per unit:
Manufacturing:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . .
Variable selling and administrative . . . . . . . . . . . . . . . .
$6
$9
$3
$4
Fixed costs per year:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . .
Fixed selling and administrative . . . . . . . . . . . . . . . .
$300,000
$190,000
During the year, the company produced 25,000 units and sold 20,000 units. The selling price of the
company’s product is $50 per unit.
Required:
1.
2.
Assume that the company uses absorption costing:
a. Compute the unit product cost.
b. Prepare an income statement for the year.
Assume that the company uses variable costing:
a. Compute the unit product cost.
b. Prepare an income statement for the year.
EXERCISE 6–7 Segmented Income Statement [LO6–4]
Shannon Company segments its income statement into its North and South Divisions. The company’s overall sales, contribution margin ratio, and net operating income are $500,000, 46%, and
$10,000, respectively. The North Division’s contribution margin and contribution margin ratio are
$150,000 and 50%, respectively. The South Division’s segment margin is $30,000. The company
has $90,000 of common fixed expenses that cannot be traced to either division.
Required:
Prepare an income statement for Shannon Company that uses the contribution format and is segmented by divisions. In addition, for the company as a whole and for each segment, show each
item on the segmented income statements as a percent of sales.
EXERCISE 6–8 Deducing Changes in Inventories [LO6–3]
Parker Products Inc, a manufacturer, reported $123 million in sales and a loss of $18 million in its
annual report to shareholders. According to a CVP analysis prepared for management, the company’s break-even point is $115 million in sales.
Variable Costing and Segment Reporting: Tools for Management
Required:
Assuming that the CVP analysis is correct, is it likely that the company’s inventory level increased,
decreased, or remained unchanged during the year? Explain.
EXERCISE 6–9 Variable and Absorption Costing Unit Product Costs and Income Statements
[LO6–1, LO6–2, LO6–3]
Walsh Company manufactures and sells one product. The following information pertains to each
of the company’s first two years of operations:
Variable costs per unit:
Manufacturing:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . .
Variable selling and administrative . . . . . . . . . . . . . .
Fixed costs per year:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . .
$25
$15
$5
$2
$250,000
$80,000
During its first year of operations, Walsh produced 50,000 units and sold 40,000 units. During its
second year of operations, it produced 40,000 units and sold 50,000 units. The selling price of the
company’s product is $60 per unit.
Required:
1.
2.
3.
Assume the company uses variable costing:
a. Compute the unit product cost for Year 1 and Year 2.
b. Prepare an income statement for Year 1 and Year 2.
Assume the company uses absorption costing:
a. Compute the unit product cost for Year 1 and Year 2.
b. Prepare an income statement for Year 1 and Year 2.
Explain the difference between variable costing and absorption costing net operating income
in Year 1. Also, explain why the two net operating income figures differ in Year 2.
EXERCISE 6–10 Companywide and Segment Break-Even Analysis [LO6–5]
Crossfire Company segments its business into two regions—East and West. The company prepared
the contribution format segmented income statement shown below:
Total
Company
East
West
Sales . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . .
$900,000
675,000
$600,000
480,000
$300,000
195,000
Contribution margin . . . . . . . . . . . . . .
Traceable fixed expenses . . . . . . . . . .
225,000
141,000
120,000
50,000
105,000
91,000
Segment margin . . . . . . . . . . . . . . . . .
Common fixed expenses . . . . . . . . . .
84,000
59,000
$ 70,000
$ 14,000
Net operating income . . . . . . . . . . . . .
$ 25,000
Required:
1.
2.
3.
4.
5.
Compute the companywide break-even point dollar in sales.
Compute the break-even point in dollar sales for the East region.
Compute the break-even point in dollar sales for the West region.
Prepare a new segmented income statement based on the break-even dollar sales that you
computed in requirements 2 and 3. Use the same format as shown above. What is Crossfire’s
net operating income in your new segmented income statement?
Do you think that Crossfire should allocate its common fixed expenses to the East and West
regions when computing the break-even points for each region? Why?
265
266
Chapter 6
EXERCISE 6–11 Segmented Income Statement [LO6–4]
Wingate Company, a wholesale distributor of electronic equipment, has been experiencing losses for
some time, as shown by its most recent monthly contribution format income statement, which follows:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . .
$1,000,000
390,000
Contribution margin . . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . .
610,000
625,000
Net operating income (loss) . . . . . . . . . . . . . .
$
(15,000)
In an effort to isolate the problem, the president has asked for an income statement segmented by
division. Accordingly, the Accounting Department has developed the following information:
Division
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses as a percentage of sales . . . . . . . . . .
Traceable fixed expenses . . . . . . . . . . . . . . . . . . . . . . . .
East
Central
West
$250,000
52%
$160,000
$400,000
30%
$200,000
$350,000
40%
$175,000
Required:
1.
2.
Prepare a contribution format income statement segmented by divisions, as desired by the
president.
As a result of a marketing study, the president believes that sales in the West Division could
be increased by 20% if monthly advertising in that division were increased by $15,000. Would
you recommend the increased advertising? Show computations to support your answer.
EXERCISE 6–12 Variable Costing Income Statement; Reconciliation [LO6–2, LO6–3]
Whitman Company has just completed its first year of operations. The company’s absorption costing income statement for the year appears below:
Whitman Company
Income Statement
Sales (35,000 units 3 $25 per unit) . . . . . . . . . . . . . . . . . . . .
Cost of goods sold (35,000 units 3 $16 per unit) . . . . . . . . .
$875,000
560,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . . . . . . . . . . .
315,000
280,000
Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 35,000
The company’s selling and administrative expenses consist of $210,000 per year in fixed expenses
and $2 per unit sold in variable expenses. The $16 per unit product cost given above is computed
as follows:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead ($160,000 4 40,000 units) . . . . . . .
$ 5
6
1
4
Absorption costing unit product cost . . . . . . . . . . . . . . . . . . . . . . . .
$16
Required:
1.
2.
Redo the company’s income statement in the contribution format using variable costing.
Reconcile any difference between the net operating income on your variable costing income
statement and the net operating income on the absorption costing income statement above.
Variable Costing and Segment Reporting: Tools for Management
EXERCISE 6–13 Inferring Costing Method; Unit Product Cost [LO6–1]
Sierra Company incurs the following costs to produce and sell a single product.
Variable costs per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . . . .
Variable selling and administrative expenses . . . . . . . .
$9
$10
$5
$3
Fixed costs per year:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . . .
$150,000
$400,000
During the last year, 25,000 units were produced and 22,000 units were sold. The Finished Goods
inventory account at the end of the year shows a balance of $72,000 for the 3,000 unsold units.
Required:
1.
2.
Is the company using absorption costing or variable costing to cost units in the Finished
Goods inventory account? Show computations to support your answer.
Assume that the company wishes to prepare financial statements for the year to issue to its
stockholders.
a. Is the $72,000 figure for Finished Goods inventory the correct amount to use on these
statements for external reporting purposes? Explain.
b. At what dollar amount should the 3,000 units be carried in the inventory for external
reporting purposes?
EXERCISE 6–14 Variable Costing Unit Product Cost and Income Statement; Break-Even [LO6–1, LO6–2]
Chuck Wagon Grills, Inc., makes a single product—a handmade specialty barbecue grill that it
sells for $210. Data for last year’s operations follow:
Units in beginning inventory . . . . . . . . . . . . . . . . . . . . . . .
Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units in ending inventory . . . . . . . . . . . . . . . . . . . . . . . . .
0
20,000
19,000
1,000
Variable costs per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . . . .
Variable selling and administrative . . . . . . . . . . . . . . . .
$ 50
80
20
10
Total variable cost per unit . . . . . . . . . . . . . . . . . . . . . .
$160
Fixed costs:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative . . . . . . . . . . . . . . . . . .
$700,000
285,000
Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$985,000
Required:
1.
2.
3.
Assume that the company uses variable costing. Compute the unit product cost for one barbecue grill.
Assume that the company uses variable costing. Prepare a contribution format income statement for the year.
What is the company’s break-even point in terms of the number of barbecue grills sold?
EXERCISE 6–15 Absorption Costing Unit Product Cost and Income Statement [LO6–1, LO6–2]
Refer to the data in Exercise 6–14 for Chuck Wagon Grills. Assume in this exercise that the company uses absorption costing.
Required:
1.
2.
Compute the unit product cost for one barbecue grill.
Prepare an income statement.
267
268
Chapter 6
EXERCISE 6–16 Working with a Segmented Income Statement; Break-Even Analysis [LO6–4, LO6–5]
Raner, Harris, & Chan is a consulting firm that specializes in information systems for medical and
dental clinics. The firm has two offices—one in Chicago and one in Minneapolis. The firm classifies the direct costs of consulting jobs as variable costs. A contribution format segmented income
statement for the company’s most recent year is given below:
Office
Total Company
Chicago
Minneapolis
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$450,000
225,000
100%
50%
$150,000
45,000
100%
30%
$300,000
180,000
100%
60%
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Traceable fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . .
225,000
126,000
50%
28%
105,000
78,000
70%
52%
120,000
48,000
40%
16%
Office segment margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common fixed expenses not traceable to offices . . . . . . .
99,000
63,000
22%
14%
$ 27,000
18%
$ 72,000
24%
Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 36,000
8%
Required:
1.
2.
3.
Compute the companywide break-even point in dollar sales. Also, compute the break-even
point for the Chicago office and for the Minneapolis office. Is the companywide breakeven point greater than, less than, or equal to the sum of the Chicago and Minneapolis
break-even points? Why?
By how much would the company’s net operating income increase if Minneapolis increased
its sales by $75,000 per year? Assume no change in cost behavior patterns.
Refer to the original data. Assume that sales in Chicago increase by $50,000 next year and
that sales in Minneapolis remain unchanged. Assume no change in fixed costs.
a. Prepare a new segmented income statement for the company using the above format.
Show both amounts and percentages.
b. Observe from the income statement you have prepared that the contribution margin ratio
for Chicago has remained unchanged at 70% (the same as in the above data) but that the
segment margin ratio has changed. How do you explain the change in the segment margin ratio?
EXERCISE 6–17 Working with a Segmented Income Statement [LO6–4]
Refer to the data in Exercise 6–16. Assume that Minneapolis’ sales by major market are:
Market
Minneapolis
Medical
Dental
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$300,000
180,000
100%
60%
$200,000
128,000
100%
64%
$100,000
52,000
100%
52%
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Traceable fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . .
120,000
33,000
40%
11%
72,000
12,000
36%
6%
48,000
21,000
48%
21%
Market segment margin . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common fixed expenses not traceable to markets . . . . . . .
87,000
15,000
29%
5%
$ 60,000
30%
$ 27,000
27%
Office segment margin . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 72,000
24%
The company would like to initiate an intensive advertising campaign in one of the two market
segments during the next month. The campaign would cost $5,000. Marketing studies indicate that
such a campaign would increase sales in the Medical market by $40,000 or increase sales in the
Dental market by $35,000.
Required:
1.
2.
In which of the markets would you recommend that the company focus its advertising campaign? Show computations to support your answer.
In Exercise 6–16, Minneapolis shows $48,000 in traceable fixed expenses. What happened to
the $48,000 in this exercise?
Variable Costing and Segment Reporting: Tools for Management
269
Problems
All applicable problems are available with McGraw-Hill’s Connect® Accounting.
PROBLEM 6–18 Variable and Absorption Costing Unit Product Costs and Income Statements
[LO6–1, LO6–2]
Haas Company manufactures and sells one product. The following information pertains to each of
the company’s first three years of operations:
Variable costs per unit:
Manufacturing:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . .
Variable selling and administrative . . . . . . . . . . . . . . . .
Fixed costs per year:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . . .
$20
$12
$4
$2
$960,000
$240,000
During its first year of operations, Haas produced 60,000 units and sold 60,000 units. During its second year of operations, it produced 75,000 units and sold 50,000 units. In its third year, Haas produced
40,000 units and sold 65,000 units. The selling price of the company’s product is $58 per unit.
Required:
1.
2.
3.
4.
Compute the company’s break-even point in units sold.
Assume the company uses variable costing:
a. Compute the unit product cost for Year 1, Year 2, and Year 3.
b. Prepare an income statement for Year 1, Year 2, and Year 3.
Assume the company uses absorption costing:
a. Compute the unit product cost for Year 1, Year 2, and Year 3.
b. Prepare an income statement for Year 1, Year 2, and Year 3.
Compare the net operating income figures that you computed in requirements 2 and 3 to the
break-even point that you computed in requirement 1. Which net operating income figures
seem counterintuitive? Why?
PROBLEM 6–19 Variable Costing Income Statement; Reconciliation [LO6–2, LO6–3]
During Heaton Company’s first two years of operations, the company reported absorption costing
net operating income as follows:
Year 1
Year 2
Sales (@ $25 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold (@ $18 per unit) . . . . . . . . . . . . . . . . . . . . . .
$1,000,000
720,000
$1,250,000
900,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses* . . . . . . . . . . . . . . . . . . . . .
280,000
210,000
350,000
230,000
70,000
$ 120,000
Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$
*$2 per unit variable; $130,000 fixed each year.
The company’s $18 unit product cost is computed as follows:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead ($270,000 4 45,000 units) . . . . . . .
$ 4
7
1
6
Absorption costing unit product cost . . . . . . . . . . . . . . . . . . . . . . . .
$18
Forty percent of fixed manufacturing overhead consists of wages and salaries; the remainder consists of depreciation charges on production equipment and buildings.
270
Chapter 6
Production and cost data for the two years are:
Units produced . . . . . . . . . .
Units sold . . . . . . . . . . . . .
Year 1
Year 2
45,000
40,000
45,000
50,000
Required:
1.
2.
Prepare a variable costing contribution format income statement for each year.
Reconcile the absorption costing and the variable costing net operating income figures for
each year.
PROBLEM 6–20 Variable and Absorption Costing Unit Product Costs and Income Statements;
Explanation of Difference in Net Operating Income [LO6–1, LO6–2, LO6–3]
High Country, Inc., produces and sells many recreational products. The company has just opened
a new plant to produce a folding camp cot that will be marketed throughout the United States. The
following cost and revenue data relate to May, the first month of the plant’s operation:
Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Variable per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed (per month) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing costs:
Direct materials cost per unit . . . . . . . . . . . . . . . . . . . . . .
Direct labor cost per unit . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead cost per unit . . . . . . . .
Fixed manufacturing overhead cost (per month) . . . . . . .
0
10,000
8,000
$75
$6
$200,000
$20
$8
$2
$100,000
Management is anxious to see how profitable the new camp cot will be and has asked that an
income statement be prepared for May.
Required:
1.
2.
3.
Assume that the company uses absorption costing.
a. Determine the unit product cost.
b. Prepare an income statement for May.
Assume that the company uses variable costing.
a. Determine the unit product cost.
b. Prepare a contribution format income statement for May.
Explain the reason for any difference in the ending inventory balances under the two costing
methods and the impact of this difference on reported net operating income.
PROBLEM 6–21 Segment Reporting and Decision-Making [LO6–4]
Vulcan Company’s contribution format income statement for June is given below:
Vulcan Company
Income Statement
For the Month Ended June 30
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable expenses . . . . . . . . . . . . . . . . . . . . . . .
$750,000
336,000
Contribution margin . . . . . . . . . . . . . . . . . . . . . .
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . .
414,000
378,000
Net operating income . . . . . . . . . . . . . . . . . . . .
$ 36,000
Management is disappointed with the company’s performance and is wondering what can be
done to improve profits. By examining sales and cost records, you have determined the following:
a. The company is divided into two sales territories—Northern and Southern. The Northern territory recorded $300,000 in sales and $156,000 in variable expenses during June; the remaining sales and variable expenses were recorded in the Southern territory. Fixed expenses of
$120,000 and $108,000 are traceable to the Northern and Southern territories, respectively.
The rest of the fixed expenses are common to the two territories.
Variable Costing and Segment Reporting: Tools for Management
b.
The company is the exclusive distributor for two products—Paks and Tibs. Sales of Paks and
Tibs totaled $50,000 and $250,000, respectively, in the Northern territory during June. Variable expenses are 22% of the selling price for Paks and 58% for Tibs. Cost records show that
$30,000 of the Northern territory’s fixed expenses are traceable to Paks and $40,000 to Tibs,
with the remainder common to the two products.
Required:
1.
2.
3.
Prepare contribution format segmented income statements first showing the total company
broken down between sales territories and then showing the Northern territory broken down
by product line. In addition, for the company as a whole and for each segment, show each item
on the segmented income statements as a percent of sales.
Look at the statement you have prepared showing the total company segmented by sales territory. What insights revealed by this statement should be brought to the attention of management?
Look at the statement you have prepared showing the Northern territory segmented by product
lines. What insights revealed by this statement should be brought to the attention of management?
PROBLEM 6–22 Prepare and Reconcile Variable Costing Statements [LO6–1, LO6–2, LO6–3]
Denton Company manufactures and sells a single product. Cost data for the product are given below:
Variable costs per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . .
Variable selling and administrative . . . . . . . . .
$ 7
10
5
3
Total variable cost per unit . . . . . . . . . . . . . . .
$25
Fixed costs per month:
Fixed manufacturing overhead . . . . . . . . . . . .
Fixed selling and administrative . . . . . . . . . . .
$315,000
245,000
Total fixed cost per month . . . . . . . . . . . . . . .
$560,000
The product sells for $60 per unit. Production and sales data for July and August, the first two
months of operations, follow:
July . . . . . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . . . . . . .
Units
Produced
Units
Sold
17,500
17,500
15,000
20,000
The company’s Accounting Department has prepared absorption costing income statements for
July and August as presented below:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . .
Net operating income . . . . . . . . . . . . . . . . . . . . . .
July
August
$900,000
600,000
300,000
290,000
$ 10,000
$1,200,000
800,000
400,000
305,000
$ 95,000
Required:
1.
2.
3.
4.
Determine the unit product cost under:
a. Absorption costing.
b. Variable costing.
Prepare contribution format variable costing income statements for July and August.
Reconcile the variable costing and absorption costing net operating income figures.
The company’s Accounting Department has determined the company’s break-even point to be
16,000 units per month, computed as follows:
Fixed cost per month
$560,000
_____________________
5 __________ 5 16,000 units
Unit contribution margin $35 per unit
271
272
Chapter 6
“I’m confused,” said the president. “The accounting people say that our break-even point is
16,000 units per month, but we sold only 15,000 units in July, and the income statement they
prepared shows a $10,000 profit for that month. Either the income statement is wrong or the
break-even point is wrong.” Prepare a brief memo for the president, explaining what happened
on the July absorption costing income statement.
PROBLEM 6–23 Absorption and Variable Costing; Production Constant, Sales Fluctuate [LO6–1,
LO6–2, LO6–3]
Tami Tyler opened Tami’s Creations, Inc., a small manufacturing company, at the beginning of the
year. Getting the company through its first quarter of operations placed a considerable strain on
Ms. Tyler’s personal finances. The following income statement for the first quarter was prepared
by a friend who has just completed a course in managerial accounting at State University.
Tami’s Creations, Inc.
Income Statement
For the Quarter Ended March 31
Sales (28,000 units) . . . . . . . . . . . . . . . . . . . . . .
Variable expenses:
Variable cost of goods sold . . . . . . . . . . . . . .
Variable selling and administrative . . . . . . . . .
Contribution margin . . . . . . . . . . . . . . . . . . . . . .
Fixed expenses:
Fixed manufacturing overhead . . . . . . . . . . . .
Fixed selling and administrative . . . . . . . . . . .
$1,120,000
$462,000
168,000
630,000
490,000
300,000
200,000
Net operating loss . . . . . . . . . . . . . . . . . . . . . . .
500,000
$
(10,000)
Ms. Tyler is discouraged over the loss shown for the quarter, particularly because she had
planned to use the statement as support for a bank loan. Another friend, a CPA, insists that the company should be using absorption costing rather than variable costing and argues that if absorption
costing had been used the company probably would have reported at least some profit for the quarter.
At this point, Ms. Tyler is manufacturing only one product, a swimsuit. Production and cost
data relating to the swimsuit for the first quarter follow:
Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . .
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
30,000
28,000
Variable costs per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . . . .
Variable selling and administrative . . . . . . . . . . .
$3.50
$12.00
$1.00
$6.00
Required:
1.
2.
3.
Complete the following:
a. Compute the unit product cost under absorption costing.
b. Redo the company’s income statement for the quarter using absorption costing.
c. Reconcile the variable and absorption costing net operating income (loss) figures.
Was the CPA correct in suggesting that the company really earned a “profit” for the quarter?
Explain.
During the second quarter of operations, the company again produced 30,000 units but sold
32,000 units. (Assume no change in total fixed costs.)
a. Prepare a contribution format income statement for the quarter using variable costing.
b. Prepare an income statement for the quarter using absorption costing.
c. Reconcile the variable costing and absorption costing net operating incomes.
PROBLEM 6–24 Companywide and Segment Break-Even Analysis; Decision Making [LO6–4, LO6–5]
Toxaway Company is a merchandiser that segments its business into two divisions—Commercial
and Residential. The company’s accounting intern was asked to prepare segmented income statements that the company’s divisional managers could use to calculate their break-even points and
Variable Costing and Segment Reporting: Tools for Management
make decisions. She took the prior month’s companywide income statement and prepared the
absorption format segmented income statement shown below:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . .
Net operating income . . . . . . . . . . . . . . . . . . . . .
Total
Company
Commercial
Residential
$750,000
500,000
250,000
240,000
$ 10,000
$250,000
140,000
110,000
104,000
$ 6,000
$500,000
360,000
140,000
136,000
$ 4,000
In preparing these statements, the intern determined that Toxaway’s only variable selling and
administrative expense is a 10% sales commission on all sales. The company’s total fixed expenses
include $72,000 of common fixed expenses that would continue to be incurred even if the Commercial or Residential segments are discontinued, $38,000 of fixed expenses that would be avoided
if the Residential segment is dropped, and $55,000 of fixed expenses that would be avoided if the
Commericial segment is dropped.
Required:
1.
2.
3.
4.
5.
6.
Do you agree with the intern’s decision to use an absorption format for her segmented income
statement? Why?
Based on the intern’s segmented income statement, can you determine how she allocated the
company’s common fixed expenses to the Commercial and Residential segments? Do you
agree with her decision to allocate the common fixed expenses to the Commercial and Residential segments?
Redo the intern’s segmented income statement using the contribution format.
Compute the companywide break-even point in dollar sales.
Compute the break-even point in dollar sales for the Commercial Division and for the Residential Division.
Assume the company decided to pay its sales representatives in the Commercial and Residential Divisions a total monthly salary of $15,000 and $30,000, respectively, and to lower its
companywide sales commission percentage from 10% to 5%. Calculate the new break-even
point in dollar sales for the Commercial Division and the Residential Division.
PROBLEM 6–25 Prepare and Interpret Income Statements; Changes in Both Sales and Production;
Lean Production [LO6–1, LO6–2, LO6–3]
Starfax, Inc., manufactures a small part that is widely used in various electronic products such as
home computers. Operating results for the first three years of activity were as follows (absorption
costing basis):
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . . . .
Net operating income (loss) . . . . . . . . . . . . . . . . . . .
Year 1
Year 2
Year 3
$800,000
580,000
220,000
190,000
$ 30,000
$640,000
400,000
240,000
180,000
$ 60,000
$800,000
620,000
180,000
190,000
$ (10,000)
In the latter part of Year 2, a competitor went out of business and in the process dumped a
large number of units on the market. As a result, Starfax’s sales dropped by 20% during Year 2
even though production increased during the year. Management had expected sales to remain constant at 50,000 units; the increased production was designed to provide the company with a buffer
of protection against unexpected spurts in demand. By the start of Year 3, management could see
that inventory was excessive and that spurts in demand were unlikely. To reduce the excessive
inventories, Starfax cut back production during Year 3, as shown below:
Production in units . . . . . . . .
Sales in units . . . . . . . . . . . .
Year 1
Year 2
Year 3
50,000
50,000
60,000
40,000
40,000
50,000
273
274
Chapter 6
a.
b.
c.
d.
Additional information about the company follows:
The company’s plant is highly automated. Variable manufacturing expenses (direct materials,
direct labor, and variable manufacturing overhead) total only $2 per unit, and fixed manufacturing overhead expenses total $480,000 per year.
Fixed manufacturing overhead costs are applied to units of product on the basis of each year’s
production. That is, a new fixed manufacturing overhead rate is computed each year.
Variable selling and administrative expenses were $1 per unit sold in each year. Fixed selling
and administrative expenses totaled $140,000 per year.
The company uses a FIFO inventory flow assumption.
Starfax’s management can’t understand why profits doubled during Year 2 when sales dropped by
20% and why a loss was incurred during Year 3 when sales recovered to previous levels.
Required:
1.
2.
3.
4.
5.
Prepare a contribution format variable costing income statement for each year.
Refer to the absorption costing income statements above.
a. Compute the unit product cost in each year under absorption costing. (Show how much
of this cost is variable and how much is fixed.)
b. Reconcile the variable costing and absorption costing net operating income figures for
each year.
Refer again to the absorption costing income statements. Explain why net operating income
was higher in Year 2 than it was in Year 1 under the absorption approach, in light of the fact
that fewer units were sold in Year 2 than in Year 1.
Refer again to the absorption costing income statements. Explain why the company suffered a loss
in Year 3 but reported a profit in Year 1 although the same number of units was sold in each year.
a. Explain how operations would have differed in Year 2 and Year 3 if the company had
been using Lean Production, with the result that ending inventory was zero.
b. If Lean Production had been used during Year 2 and Year 3 and the predetermined overhead rate is based on 50,000 units per year, what would the company’s net operating
income (or loss) have been in each year under absorption costing? Explain the reason for
any differences between these income figures and the figures reported by the company in
the statements above.
PROBLEM 6–26 Restructuring a Segmented Income Statement [LO6–4]
Losses have been incurred at Millard Corporation for some time. In an effort to isolate the problem
and improve the company’s performance, management has requested that the monthly income
statement be segmented by sales region. The company’s first effort at preparing a segmented statement is given below. This statement is for May, the most recent month of activity.
Sales Region
West
Central
East
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$450,000
$800,000
$ 750,000
Regional expenses (traceable):
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . .
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shipping expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .
162,900
108,000
90,000
13,500
27,000
17,100
280,000
200,000
88,000
12,000
28,000
32,000
376,500
210,000
135,000
15,000
30,000
28,500
Total regional expenses . . . . . . . . . . . . . . . . . . . . . . . . .
418,500
640,000
795,000
Regional income (loss) before corporate expenses . . . .
31,500
160,000
(45,000)
Corporate expenses:
Advertising (general) . . . . . . . . . . . . . . . . . . . . . . . . . .
General administrative expense . . . . . . . . . . . . . . . . .
18,000
50,000
32,000
50,000
30,000
50,000
Total corporate expenses . . . . . . . . . . . . . . . . . . . . . . . .
68,000
82,000
80,000
Net operating income (loss) . . . . . . . . . . . . . . . . . . . . . .
$ (36,500)
$ 78,000
$(125,000)
Variable Costing and Segment Reporting: Tools for Management
Cost of goods sold and shipping expense are both variable; other costs are all fixed.
Millard Corporation is a wholesale distributor of office products. It purchases office products
from manufacturers and distributes them in the three regions given above. The three regions are
about the same size, and each has its own manager and sales staff. The products that the company
distributes vary widely in profitability.
Required:
1.
2.
3.
4.
List any disadvantages or weaknesses that you see to the statement format illustrated on the
previous page.
Explain the basis that is apparently being used to allocate the corporate expenses to the
regions. Do you agree with these allocations? Explain.
Prepare a new contribution format segmented income statement for May. Show a Total column as well as data for each region. In addition, for the company as a whole and for each sales
region, show each item on the segmented income statement as a percent of sales.
Analyze the statement that you prepared in part (3) above. What points that might help to
improve the company’s performance would you bring to management’s attention?
PROBLEM 6–27 Incentives Created by Absorption Costing; Ethics and the Manager [LO6–2]
Carlos Cavalas, the manager of Echo Products’ Brazilian Division, is trying to set the production
schedule for the last quarter of the year. The Brazilian Division had planned to sell 3,600 units during the year, but by September 30 only the following activity had been reported:
Units
Inventory, January 1 . . . . . . . . . . . . . . . . . . . .
Production . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory, September 30 . . . . . . . . . . . . . . . . .
0
2,400
2,000
400
The division can rent warehouse space to store up to 1,000 units. The minimum inventory
level that the division should carry is 50 units. Mr. Cavalas is aware that production must be at least
200 units per quarter in order to retain a nucleus of key employees. Maximum production capacity
is 1,500 units per quarter.
Demand has been soft, and the sales forecast for the last quarter is only 600 units. Due
to the nature of the division’s operations, fixed manufacturing overhead is a major element of
product cost.
Required:
1.
2.
3.
Assume that the division is using variable costing. How many units should be scheduled for
production during the last quarter of the year? (The basic formula for computing the required
production for a period in a company is: Expected sales 1 Desired ending inventory 2
Beginning inventory 5 Required production.) Show computations and explain your answer.
Will the number of units scheduled for production affect the division’s reported income or
loss for the year? Explain.
Assume that the division is using absorption costing and that the divisional manager is given
an annual bonus based on divisional operating income. If Mr. Cavalas wants to maximize his
division’s operating income for the year, how many units should be scheduled for production
during the last quarter? [See the formula in (1) above.] Explain.
Identify the ethical issues involved in the decision Mr. Cavalas must make about the level of
production for the last quarter of the year.
PROBLEM 6–28 Basic Segment Reporting; Activity-Based Cost Assignment [LO6–4]
Diversified Products, Inc., has recently acquired a small publishing company that offers three
books for sale—a cookbook, a travel guide, and a handy speller. Each book sells for $10. The
publishing company’s most recent monthly income statement is given on the next page:
275
276
Chapter 6
Product Line
Total
Company
Cookbook
Travel
Guide
Handy
Speller
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$300,000
$90,000
$150,000
$60,000
Expenses:
Printing costs . . . . . . . . . . . . . . . . . . . . . .
Advertising . . . . . . . . . . . . . . . . . . . . . . . .
General sales . . . . . . . . . . . . . . . . . . . . . .
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . .
Equipment depreciation . . . . . . . . . . . . . .
Sales commissions . . . . . . . . . . . . . . . . .
General administration . . . . . . . . . . . . . . .
Warehouse rent . . . . . . . . . . . . . . . . . . . .
Depreciation—office facilities . . . . . . . . .
102,000
36,000
18,000
33,000
9,000
30,000
42,000
12,000
3,000
27,000
13,500
5,400
18,000
3,000
9,000
14,000
3,600
1,000
63,000
19,500
9,000
9,000
3,000
15,000
14,000
6,000
1,000
12,000
3,000
3,600
6,000
3,000
6,000
14,000
2,400
1,000
Total expenses . . . . . . . . . . . . . . . . . . . . . . .
285,000
94,500
139,500
51,000
Net operating income (loss) . . . . . . . . . . . . .
$ 15,000
$ (4,500)
$ 10,500
$ 9,000
The following additional information is available about the company:
Only printing costs and sales commissions are variable; all other costs are fixed. The printing
costs (which include materials, labor, and variable overhead) are traceable to the three product
lines as shown in the statement above. Sales commissions are 10% of sales for any product.
b. The same equipment is used to produce all three books, so the equipment depreciation cost
has been allocated equally among the three product lines. An analysis of the company’s activities indicates that the equipment is used 30% of the time to produce cookbooks, 50% of the
time to produce travel guides, and 20% of the time to produce handy spellers.
c. The warehouse is used to store finished units of product, so the rental cost has been allocated
to the product lines on the basis of sales dollars. The warehouse rental cost is $3 per square
foot per year. The warehouse contains 48,000 square feet of space, of which 7,200 square feet
is used by the cookbook line, 24,000 square feet by the travel guide line, and 16,800 square
feet by the handy speller line.
d. The general sales cost above includes the salary of the sales manager and other sales costs not
traceable to any specific product line. This cost has been allocated to the product lines on the
basis of sales dollars.
e. The general administration cost and depreciation of office facilities both relate to administration of the company as a whole. These costs have been allocated equally to the three product
lines.
f. All other costs are traceable to the three product lines in the amounts shown on the statement
above.
The management of Diversified Products, Inc., is anxious to improve the publishing company’s 5% return on sales.
a.
Required:
1.
2.
Prepare a new contribution format segmented income statement for the month. Adjust allocations of equipment depreciation and of warehouse rent as indicated by the additional information provided.
After seeing the income statement in the main body of the problem, management has decided
to eliminate the cookbook because it is not returning a profit, and to focus all available
resources on promoting the travel guide.
a. Based on the statement you have prepared, do you agree with the decision to eliminate
the cookbook? Explain.
b. Based on the statement you have prepared, do you agree with the decision to focus
all available resources on promoting the travel guide? Assume that an ample market is
available for all three product lines. (Hint: Compute the contribution margin ratio for
each product.)
Variable Costing and Segment Reporting: Tools for Management
277
Cases
All applicable cases are available with McGraw-Hill’s Connect® Accounting.
CASE 6–29 Variable and Absorption Costing Unit Product Costs and Income Statements [LO6–1, LO6–2]
O’Brien Company manufactures and sells one product. The following information pertains to each
of the company’s first three years of operations:
Variable costs per unit:
Manufacturing:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing overhead . . . . . . . . . .
Variable selling and administrative . . . . . . . . . . .
Fixed costs per year:
Fixed manufacturing overhead . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . .
$32
$20
$4
$3
$660,000
$120,000
During its first year of operations, O’Brien produced 100,000 units and sold 80,000 units. During its second year of operations, it produced 75,000 units and sold 90,000 units. In its third year,
O’Brien produced 80,000 units and sold 75,000 units. The selling price of the company’s product
is $75 per unit.
Required:
1.
2.
3.
4.
Assume the company uses variable costing and a FIFO inventory flow assumption (FIFO
means first-in first-out. In other words, it assumes that the oldest units in inventory are
sold first):
a. Compute the unit product cost for Year 1, Year 2, and Year 3.
b. Prepare an income statement for Year 1, Year 2, and Year 3.
Assume the company uses variable costing and a LIFO inventory flow assumption (LIFO
means last-in first-out. In other words, it assumes that the newest units in inventory are
sold first):
a. Compute the unit product cost for Year 1, Year 2, and Year 3.
b. Prepare an income statement for Year 1, Year 2, and Year 3.
Assume the company uses absorption costing and a FIFO inventory flow assumption
(FIFO means first-in first-out. In other words, it assumes that the oldest units in inventory
are sold first):
a. Compute the unit product cost for Year 1, Year 2, and Year 3.
b. Prepare an income statement for Year 1, Year 2, and Year 3.
Assume the company uses absorption costing and a LIFO inventory flow assumption
(LIFO means last-in first-out. In other words, it assumes that the newest units in inventory
are sold first):
a. Compute the unit product cost for Year 1, Year 2, and Year 3.
b. Prepare an income statement for Year 1, Year 2, and Year 3.
CASE 6–30 Service Organization; Segment Reporting [LO6–4]
Music Teachers, Inc., is an educational association for music teachers that has 20,000 members. The association operates from a central headquarters but has local membership chapters throughout the United States. Monthly meetings are held by the local chapters to discuss
recent developments on topics of interest to music teachers. The association’s journal, Teachers’
Forum, is issued monthly with features about recent developments in the field. The association
publishes books and reports and also sponsors professional courses that qualify for continuing
278
Chapter 6
professional education credit. The association’s statement of revenues and expenses for the current year is presented below.
Music Teachers, Inc.
Statement of Revenues and Expenses
For the Year Ended November 30
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,275,000
Expenses:
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Personnel costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Occupancy costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reimbursement of member costs to local chapters . . . . . .
Other membership services . . . . . . . . . . . . . . . . . . . . . . . .
Printing and paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Postage and shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Instructors’ fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative . . . . . . . . . . . . . . . . . . . . . . . . .
920,000
230,000
280,000
600,000
500,000
320,000
176,000
80,000
38,000
Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3,144,000
Excess of revenues over expenses . . . . . . . . . . . . . . . . . . . .
$ 131,000
The board of directors of Music Teachers, Inc., has requested that a segmented income statement be prepared showing the contribution of each segment to the association. The association
has four segments: Membership Division, Magazine Subscriptions Division, Books and Reports
Division, and Continuing Education Division. Mike Doyle has been assigned responsibility for
preparing the segmented income statement, and he has gathered the following data prior to its
preparation.
a. Membership dues are $100 per year, of which $20 is considered to cover a one-year subscription to the association’s journal. Other benefits include membership in the association and
chapter affiliation. The portion of the dues covering the magazine subscription ($20) should
be assigned to the Magazine Subscription Division.
b. One-year subscriptions to Teachers’ Forum were sold to nonmembers and libraries at $30 per
subscription. A total of 2,500 of these subscriptions were sold last year. In addition to subscriptions, the magazine generated $100,000 in advertising revenues. The costs per magazine
subscription were $7 for printing and paper and $4 for postage and shipping.
c. A total of 28,000 technical reports and professional texts were sold by the Books and Reports
Division at an average unit selling price of $25. Average costs per publication were $4 for
printing and paper and $2 for postage and shipping.
d. The association offers a variety of continuing education courses to both members and nonmembers. The one-day courses had a tuition cost of $75 each and were attended by 2,400 students. A total of 1,760 students took two-day courses at a tuition cost of $125 for each student.
Outside instructors were paid to teach some courses.
e. Salary costs and space occupied by division follow:
Salaries
Space Occupied
(square feet)
Membership . . . . . . . . . . . . . . .
Magazine Subscriptions . . . . . . .
Books and Reports . . . . . . . . . .
Continuing Education . . . . . . . . .
Corporate staff . . . . . . . . . . . . .
$210,000
150,000
300,000
180,000
80,000
2,000
2,000
3,000
2,000
1,000
Total . . . . . . . . . . . . . . . . . . . . . .
$920,000
10,000
Personnel costs are 25% of salaries in the separate divisions as well as for the corporate staff.
The $280,000 in occupancy costs includes $50,000 in rental cost for a warehouse used by the
Books and Reports Division for storage purposes.
Variable Costing and Segment Reporting: Tools for Management
279
f.
Printing and paper costs other than for magazine subscriptions and for books and reports
relate to the Continuing Education Division.
g. General and administrative expenses include costs relating to overall administration of the
association as a whole. The company’s corporate staff does some mailing of materials for
general administrative purposes.
The expenses that can be traced or assigned to the corporate staff, as well as any other
expenses that are not traceable to the segments, will be treated as common costs. It is not necessary
to distinguish between variable and fixed costs.
Required:
1.
2.
Prepare a contribution format segmented income statement for Music Teachers, Inc. This
statement should show the segment margin for each division as well as results for the association as a whole.
Give arguments for and against allocating all costs of the association to the four divisions.
(CMA, adapted)
Appendix 6A: Super-Variable Costing
In the discussion of variable costing in this chapter we have assumed that direct labor and
a portion of manufacturing overhead are variable costs that should be attached to products.
However, these assumptions about cost behavior may not be true. For example, it may be
easier and more accurate to assume that all manufacturing overhead costs are fixed costs
because the variable portion of these costs is insignificant or too difficult to estimate. Furthermore, many companies’ labor costs (including direct and indirect labor) are more fixed
than variable due to labor regulations, labor contracts, or management policy. In countries such as France, Germany, Spain, and Japan, management often has little flexibility
in adjusting the labor force to changes in business activity. Even in countries such as the
United States and the United Kingdom, where management usually has greater latitude to
adjust the size of its labor force, many managers choose to view labor as a fixed cost. They
make this choice because the cost savings from terminating or laying off employees during a short-term business downturn may be swamped by the negative effects on employee
morale and by the costs of later finding and training suitable replacements. Moreover,
treating employees as variable costs subtly fosters the attitude that employees are expendable and replaceable like materials rather than unique, difficult-to-replace assets.
Super-variable costing is a variation on variable costing in which direct labor and
manufacturing overhead costs are considered to be fixed. Super-variable costing classifies all direct labor and manufacturing overhead costs as fixed period costs and only
direct materials as a variable product cost. To simplify, in this appendix we also assume
that selling and administrative expenses are entirely fixed.
Super-Variable Costing and Variable Costing—An Example
To illustrate the difference between treating direct labor as a fixed cost (as in supervariable costing) and treating direct labor as a variable cost (as in variable costing), we
will use a modified version of the Weber Light Aircraft example from the main body of
the chapter. Data concerning the company’s operations appear below:
Per Aircraft
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct materials . . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead . . . . . . . . . . . .
Fixed selling and administrative expense . . .
Per Month
$100,000
$19,000
$20,000
$74,000
$40,000
LO6–6
Prepare an income statement
using super-variable costing
and reconcile this approach
with variable costing.
280
Chapter 6
Beginning inventory . . . . . . . . . . . . . .
Units produced . . . . . . . . . . . . . . . . .
Units sold . . . . . . . . . . . . . . . . . . . . .
Ending inventory . . . . . . . . . . . . . . . .
January
February
March
0
2
2
0
0
2
1
1
1
2
3
0
The key thing to notice here is that direct labor is a fixed cost—$20,000 per month.
Also, notice that Weber Light Aircraft has no variable manufacturing overhead costs and
no variable selling and administrative expenses. For the months of January, February,
and March, the company’s selling price per aircraft, variable cost per aircraft, monthly
production in units, and total monthly fixed expenses never change. The only thing that
changes in this example is the number of units sold (January 5 2 units sold; February 5
1 unit sold; March 5 3 units sold).
We will first construct the company’s super-variable costing income statements for
January, February, and March. Then we will show how the company’s net operating
income would be determined for the same months using variable costing if it were incorrectly assumed that direct labor is a variable cost. As you’ll see, both income statements
rely on the contribution format.
Super-Variable Costing Income Statements
To prepare the company’s super-variable costing income statements for each month we follow four steps. First, we compute sales by multiplying the number of units sold by the selling
price per unit, which in this example is $100,000 per unit. Second, we compute the variable
cost of goods sold by multiplying the number of units sold by the unit product cost, which in
this example is the direct materials cost of $19,000 per unit. Third, we compute the contribution margin by subtracting the variable cost of goods sold from sales. Fourth, we compute
net operating income by subtracting all fixed expenses from the contribution margin.
Using these four steps, Weber’s super-variable costing income statements for each
month would appear as shown in Exhibit 6A–1. Notice that the only variable expense is
variable cost of goods sold, which is the $19,000 of direct materials per unit sold. For example, in March, the unit product cost of $19,000 is multiplied by three units sold to obtain
the variable cost of goods sold of $57,000. The total monthly fixed manufacturing expenses
of $94,000 include $20,000 of direct labor and $74,000 of fixed manufacturing overhead.
EXHIBIT 6A–1
Super-Variable Costing Income
Statements
Sales (@ $100,000 per unit) . . . . . . . . . . . . . . . .
Variable cost of goods sold
(@ $19,000 per unit) . . . . . . . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . . . . . . . . . . .
Fixed expenses:
Fixed manufacturing expenses . . . . . . . . . . . .
Fixed selling and administrative expenses . . .
Total fixed expenses . . . . . . . . . . . . . . . . . . . . .
Net operating income (loss) . . . . . . . . . . . . . . . .
January
February
March
$200,000
$100,000
$300,000
38,000
162,000
19,000
81,000
57,000
243,000
94,000
40,000
134,000
$ 28,000
94,000
40,000
134,000
$ (53,000)
94,000
40,000
134,000
$109,000
Variable Costing Income Statements
The variable costing income statements in this example differ from the super-variable
costing income statements in one important respect—we will assume that direct labor
is incorrectly classified as a variable cost and is included in unit product costs. Because
the monthly direct labor cost is $20,000 and two aircraft are produced each month, if
direct labor costs are included in unit product costs, then Weber Light Aircraft will assign
Variable Costing and Segment Reporting: Tools for Management
Sales (@ $100,000 per unit) . . . . . . . . . . . . . . . .
Variable cost of goods sold
(@ $29,000 per unit) . . . . . . . . . . . . . . . . . . . .
Contribution margin . . . . . . . . . . . . . . . . . . . . . .
Fixed expenses:
Fixed manufacturing overhead . . . . . . . . . . . .
Fixed selling and administrative expenses . . .
Total fixed expenses . . . . . . . . . . . . . . . . . . . . . .
Net operating income (loss) . . . . . . . . . . . . . . . .
January
February
March
$200,000
$100,000
$300,000
58,000
142,000
29,000
71,000
87,000
213,000
74,000
40,000
114,000
$ 28,000
74,000
40,000
114,000
$ (43,000)
74,000
40,000
114,000
$ 99,000
$10,000 of direct labor cost to each aircraft that it produces. Thus, the company’s unit
product costs under variable costing would be computed as follows:
Direct materials . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . .
Unit product cost . . . . . . . . . . .
January
February
March
$19,000
10,000
$29,000
$19,000
10,000
$29,000
$19,000
10,000
$29,000
Given these unit product cost figures, the company’s variable costing income statements would be computed as shown in Exhibit 6A–2. For example, in March, the unit
product cost of $29,000 is multiplied by three units sold to obtain the variable cost of
goods sold of $87,000. The total fixed manufacturing overhead of $74,000 and total fixed
selling and administrative expenses of $40,000 are both recorded as period expenses.
Reconciliation of Super-Variable Costing and Variable
Costing Income
The super-variable costing and variable costing net operating incomes are both $28,000 in
January. However, in February, the super-variable costing income is $10,000 lower than the
variable costing income and the opposite holds true in March. In other words, the supervariable costing income in March is $10,000 higher than the variable costing income.
Why do these two costing methods produce different net operating incomes? The
answer can be found in the accounting for direct labor costs. Super-variable costing treats
direct labor as a fixed period expense whereas variable costing treats direct labor as a variable product cost. In other words, super-variable costing records the entire direct labor
cost of $20,000 as an expense on each month’s income statement. Conversely, variable
costing assigns $10,000 of direct labor cost to each unit produced. The $10,000 assigned
to each unit produced remains in inventory on the balance sheet until the unit is sold—at
which point the $10,000 assigned to it is transferred to variable cost of goods sold on the
income statement. Given this background, the super-variable costing and variable costing
incomes for each month can be reconciled as follows:
Direct labor cost in ending inventory
(@ $10,000 per unit) . . . . . . . . . . . . . . . . . . . .
2 Direct labor cost in beginning inventory
(@ $10,000 per unit) . . . . . . . . . . . . . . . . . . . .
5 Direct labor cost deferred in
(released from) inventory . . . . . . . . . . . . . . . .
January
February
$
0
$10,000
0
0
10,000
0
$10,000
$(10,000)
$
March
$
0
281
EXHIBIT 6A–2
Variable Costing Income
Statements
282
Chapter 6
Super-variable costing net operating
income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor deferred in (released from)
inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable costing net operating income (loss) . . .
January
February
March
$28,000
$(53,000)
$109,000
0
$28,000
10,000
$(43,000)
(10,000)
$ 99,000
In January, both costing methods report the same net operating income ($28,000).
This occurs because each method expenses $20,000 of direct labor in the income statement. In February, super-variable costing income is $10,000 less than variable costing
income. This difference arises because super-variable costing expenses $20,000 of direct
labor in the income statement, whereas variable costing expenses only $10,000 of direct
labor in the income statement ($10,000 per unit 3 1 unit sold) and defers $10,000 of
direct labor on the balance sheet ($10,000 per unit 3 1 unit produced but not sold). In
March, super-variable costing income is $10,000 greater than variable costing income.
This difference arises because super-variable costing expenses $20,000 of direct labor on
the income statement, whereas variable costing expenses $30,000 of direct labor on the
income statement ($10,000 per unit 3 3 unit sold). Notice that one of the units sold in
March was actually produced in February. Under variable costing, the $10,000 of direct
labor attached to the unit produced in February is released from inventory and included in
variable cost of goods sold for March.
In summary, the key issue considered in this appendix is how a company treats
direct labor costs. If a company treats direct labor as a variable cost, the cost system
may encourage managers to treat labor costs as an expense to be minimized when sales
decline and this may result in reduced morale and eventual problems when business picks
up. Second, in practice management may have little ability to adjust the direct labor force
even if they wanted to, resulting in a situation in which direct labor costs are in fact fixed.
In either case, treating direct labor costs as variable can lead to bad decisions. The supervariable costing approach overcomes this problem by treating labor costs as fixed costs.
Glossary (Appendix 6A)
Super-variable costing A costing method that classifies all direct labor and manufacturing overhead costs as fixed period costs and only direct materials as a variable product cost. (p. 279)
Appendix 6A Exercises and Problems
All applicable exercises and problems are available with McGraw-Hill’s
Connect® Accounting.
EXERCISE 6A–1 Super-Variable Costing Income Statement [LO6–6]
Zola Company manufactures and sells one product. The following information pertains to the
company’s first year of operations:
Variable cost per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed costs per year:
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . . .
$18
$200,000
$250,000
$80,000
Variable Costing and Segment Reporting: Tools for Management
The company does not incur any variable manufacturing overhead costs or variable selling and
administrative expenses. During its first year of operations, Zola produced 25,000 units and sold
20,000 units. The selling price of the company’s product is $50 per unit.
Required:
1.
Assume the company uses super-variable costing:
a. Compute the unit product cost for the year.
b. Prepare an income statement for the year.
EXERCISE 6A–2 Super-Variable Costing and Variable Costing Unit Product Costs and Income
Statements [LO6–2, LO6–6]
Lyons Company manufactures and sells one product. The following information pertains to the
company’s first year of operations:
Variable cost per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed costs per year:
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . . .
$13
$750,000
$420,000
$110,000
The company does not incur any variable manufacturing overhead costs or variable selling and
administrative expenses. During its first year of operations, Lyons produced 60,000 units and sold
52,000 units. The selling price of the company’s product is $40 per unit.
Required:
1.
2.
3.
Assume the company uses super-variable costing:
a. Compute the unit product cost for the year.
b. Prepare an income statement for the year.
Assume the company uses a variable costing system that assigns $12.50 of direct labor cost to
each unit produced:
a. Compute the unit product cost for the year.
b. Prepare an income statement for the year.
Prepare a reconciliation that explains the difference between the super-variable costing and
variable costing net operating incomes.
EXERCISE 6A–3 Super-Variable Costing and Variable Costing Unit Product Costs and Income
Statements [LO6–2, LO6–6]
Kelly Company manufactures and sells one product. The following information pertains to each of
the company’s first two years of operations:
Variable cost per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed costs per year:
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . . .
$12
$500,000
$450,000
$180,000
The company does not incur any variable manufacturing overhead costs or variable selling and
administrative expenses. During its first year of operations, Kelly produced 50,000 units and sold
40,000 units. During its second year of operations, it produced 50,000 units and sold 60,000 units.
The selling price of the company’s product is $50 per unit.
Required:
1.
Assume the company uses super-variable costing:
a. Compute the unit product cost for Year 1 and Year 2.
b. Prepare an income statement for Year 1 and Year 2.
283
284
Chapter 6
2.
3.
Assume the company uses a variable costing system that assigns $10 of direct labor cost to
each unit produced:
a. Compute the unit product cost for Year 1 and Year 2.
b. Prepare an income statement for Year 1 and Year 2.
Prepare a reconciliation that explains the difference between the super-variable costing and
variable costing net operating incomes in Years 1 and 2.
PROBLEM 6A–4 Super-Variable Costing and Variable Costing Unit Product Costs and Income
Statements [LO6–2, LO6–6]
Ogilvy Company manufactures and sells one product. The following information pertains to each
of the company’s first three years of operations:
Variable cost per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed costs per year:
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . . .
$16
$540,000
$822,000
$370,000
The company does not incur any variable manufacturing overhead costs or variable selling and
administrative expenses. During its first year of operations, Ogilvy produced 60,000 units and
sold 60,000 units. During its second year of operations, it produced 60,000 units and sold 55,000
units. In its third year, Ogilvy produced 60,000 units and sold 65,000 units. The selling price of the
company’s product is $45 per unit.
Required:
1.
2.
3.
Assume the company uses super-variable costing:
a. Compute the unit product cost for Year 1, Year 2, and Year 3.
b. Prepare an income statement for Year 1, Year 2, and Year 3.
Assume the company uses a variable costing system that assigns $9 of direct labor cost to
each unit produced:
a. Compute the unit product cost for Year 1, Year 2, and Year 3.
b. Prepare an income statement for Year 1, Year 2, and Year 3.
Prepare a reconciliation that explains the difference between the super-variable costing and
variable costing net operating incomes in Years 1, 2, and 3.
PROBLEM 6A–5 Super-Variable Costing, Variable Costing, and Absorption Costing Income
Statements [LO6–2, LO6–6]
Bracey Company manufactures and sells one product. The following information pertains to the
company’s first year of operations:
Variable cost per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed costs per year:
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . .
Fixed selling and administrative expenses . . . . . . . . . .
$19
$250,000
$300,000
$90,000
The company does not incur any variable manufacturing overhead costs or variable selling and
administrative expenses. During its first year of operations, Bracey produced 20,000 units and sold
18,000 units. The selling price of the company’s product is $55 per unit.
Variable Costing and Segment Reporting: Tools for Management
Required:
1.
2.
3.
4.
Assume the company uses super-variable costing:
a. Compute the unit product cost for the year.
b. Prepare an income statement for the year.
Assume the company uses a variable costing system that assigns $12.50 of direct labor cost to
each unit produced:
a. Compute the unit product cost for the year.
b. Prepare an income statement for the year.
Assume the company uses an absorption costing system that assigns $12.50 of direct labor
cost and $15.00 of fixed manufacturing overhead cost to each unit produced:
a. Compute the unit product cost for the year.
b. Prepare an income statement for the year.
Prepare a reconciliation that explains the difference between the super-variable costing and
variable costing net operating incomes. Prepare another reconciliation that explains the difference between the super-variable costing and absorption costing net operating incomes.
285
CHAPTER 7
Activity-Based Costing:
A Tool to Aid Decision Making
Managing Product Complexity
BUSIN ESS FO CUS
LEARNING OBJECTIVES
After studying Chapter 7, you should be
able to:
Managers often understand that increasing the variety of raw material inputs
used in their products increases costs. For example, General Mills studied
its 50 varieties of Hamburger Helper and concluded that it could lower costs
by discontinuing half of them without alienating customers. Seagate studied
seven varieties of its computer hard drives and found that only 2% of their
parts could be shared by more than one hard drive. The engineers fixed the
problem by redesigning the hard drives so that they used more common
component parts. Instead of using 61 types of screws to make the hard
drives, the engineers reduced the number of screws needed to 19. Eventually all Seagate products were designed so that 75% of their component
parts were shared with other product lines.
Activity-based costing systems quantify the increase in costs, such as
procurement costs, material handling costs, and assembly costs that are
caused by inefficient product designs and other factors. ■
Sources: Mina Kimes, “Cereal Cost Cutters,” Fortune, November 10, 2008, p. 24; Erika Brown,
“Drive Fast, Drive Hard,” Forbes, January 9, 2006, pp. 92–96.
286
LO7–1
Understand activity-based costing
and how it differs from a traditional
costing system.
LO7–2
Assign costs to cost pools using a
first-stage allocation.
LO7–3
Compute activity rates for cost
pools.
LO7–4
Assign costs to a cost object using
a second-stage allocation.
LO7–5
Use activity-based costing to
compute product and customer
margins.
LO7–6
(Appendix 7A) Prepare an action
analysis report using activity-based
costing data and interpret the
report.
Activity-Based Costing: A Tool to Aid Decision Making
287
his chapter introduces the concept of activity-based costing which
has been embraced by a wide variety of organizations including Charles Schwab,
Citigroup, Lowe’s, Coca-Cola, J&B Wholesale, Fairchild Semiconductor,
Assan Aluminum, Sysco Foods, Fisher Scientific International, and
Peregrine Outfitters. Activity-based costing (ABC) is a costing method that is designed
to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” as well as variable costs. Activity-based costing is ordinarily used as a supplement to, rather than as a replacement for, a company’s
usual costing system. Most organizations that use activity-based costing have two costing
systems—the official costing system that is used for preparing external financial reports
and the activity-based costing system that is used for internal decision making and for
managing activities.
This chapter focuses primarily on ABC applications in manufacturing to provide a
contrast with the material presented in earlier chapters. More specifically, Chapters 3 and
4 focused on traditional absorption costing systems used by manufacturing companies
to calculate unit product costs for the purpose of valuing inventories and determining
cost of goods sold for external financial reports. In contrast, this chapter explains how
manufacturing companies can use activity-based costing rather than traditional methods
to calculate unit product costs for the purposes of managing overhead and making decisions. Chapter 6 had a similar purpose. That chapter focused on how to use variable costing to aid decisions that do not affect fixed costs. This chapter extends that idea to show
how activity-based costing can be used to aid decisions that potentially affect fixed costs
as well as variable costs.
T
Activity-Based Costing: An Overview
As stated above, traditional absorption costing is designed to provide data for external
financial reports. In contrast, activity-based costing is designed to be used for internal decision making. As a consequence, activity-based costing differs from traditional
absorption costing in three ways. In activity-based costing:
1. Nonmanufacturing as well as manufacturing costs may be assigned to products, but
only on a cause-and-effect basis.
2. Some manufacturing costs may be excluded from product costs.
3. Numerous overhead cost pools are used, each of which is allocated to products and
other cost objects using its own unique measure of activity.
Each of these departures from traditional absorption costing will be discussed in turn.
Nonmanufacturing Costs and Activity-Based Costing
In traditional absorption costing, manufacturing costs are assigned to products and nonmanufacturing costs are not assigned to products. Conversely, in activity-based costing,
we recognize that many nonmanufacturing costs relate to selling, distributing, and servicing specific products. Thus, ABC includes manufacturing and nonmanufacturing costs
when calculating the entire cost of a product rather than just its manufacturing cost.
There are two types of nonmanufacturing costs that ABC systems assign to products.
First, ABC systems trace all direct nonmanufacturing costs to products. Commissions
paid to salespersons, shipping costs, and warranty repair costs are examples of nonmanufacturing costs that can be directly traced to individual products. Second, ABC systems
allocate indirect nonmanufacturing costs to products whenever the products have presumably caused the costs to be incurred. In fact, in this chapter, we emphasize this point
by expanding the definition of overhead to include all indirect costs—manufacturing and
nonmanufacturing.
LO7–1
Understand activity-based
costing and how it differs from
a traditional costing system.
288
Chapter 7
In summary, ABC product cost calculations include all direct costs that can be
traced to products and all indirect costs that are caused by products. The need to distinguish between manufacturing and nonmanufacturing costs disappears—which is very
different from earlier chapters that focused solely on determining the manufacturing
cost of a product.
Manufacturing Costs and Activity-Based Costing
In traditional absorption costing systems, all manufacturing costs are assigned to
products—even manufacturing costs that are not caused by the products. For example, in
Chapter 3 we learned that a predetermined plantwide overhead rate is computed by dividing all budgeted manufacturing overhead costs by a measure of budgeted activity such as
direct labor-hours. This approach spreads all manufacturing overhead costs across products based on each product’s direct labor-hour usage. In contrast, activity-based costing
systems purposely do not assign two types of manufacturing overhead costs to products.
Manufacturing overhead includes costs such as the factory security guard’s wages,
the plant controller’s salary, and the cost of supplies used by the plant manager’s secretary. These types of costs are assigned to products in a traditional absorption costing system even though they are totally unaffected by which products are made during a period.
In contrast, activity-based costing systems do not arbitrarily assign these types of costs,
which are called organization-sustaining costs, to products. Activity-based costing treats
these types of costs as period expenses rather than product costs.
Additionally, in a traditional absorption costing system, the costs of unused, or idle,
capacity are assigned to products. If the budgeted level of activity declines, the overhead
rate and unit product costs increase as the increasing costs of idle capacity are spread over
a smaller base. In contrast, in activity-based costing, products are only charged for the
costs of the capacity they use—not for the costs of capacity they don’t use. This provides
more stable unit product costs and is consistent with the goal of assigning to products
only the costs of the resources that they use.1
Exhibit 7–1 summarizies the two departures from traditional absorption costing that
we have discussed thus far. The top portion of the exhibit shows that traditional absorption
costing treats all manufacturing costs as product costs and all nonmanufacturing costs as
period costs. The bottom portion of the exhibit shows that activity-based costing expands
the definition of overhead to include all indirect costs—manufacturing and nonmanufacturing. The overhead costs that are caused by products are allocated to them, whereas any
overhead costs that are not caused by products are treated as period costs. It also shows
that ABC treats direct nonmanufacturing costs as product costs rather than period costs.
Now we turn our attention to the third and final difference between traditional absorption costing and activity-based costing.
Cost Pools, Allocation Bases, and Activity-Based Costing
Throughout the 19th century and most of the 20th century, cost system designs were
simple and satisfactory. Typically, either one plantwide overhead cost pool or a number
of departmental overhead cost pools were used to assign overhead costs to products. The
plantwide and departmental approaches always had one thing in common—they relied
on allocation bases such as direct labor-hours and machine-hours for allocating overhead
costs to products. In the labor-intensive production processes of many years ago, direct
labor was the most common choice for an overhead allocation base because it represented a large component of product costs, direct labor-hours were closely tracked, and
1
Appendix 3B discusses how the costs of idle capacity can be accounted for as a period cost in an
income statement. This treatment highlights the cost of idle capacity rather than burying it in inventory
and cost of goods sold. The procedures laid out in this chapter for activity-based costing have the same
end effect.
Activity-Based Costing: A Tool to Aid Decision Making
289
EXHIBIT 7–1
Differences between Traditional Absorption Costing and Activity-Based Costing
Traditional Absorption Costing:
Manufacturing Costs
Nonmanufacturing Costs
Direct Costs
Indirect Costs
Indirect Costs
Direct Costs
Product Costs
Product Costs
Period Costs
Period Costs
Activity-Based Costing:
Manufacturing Costs
Direct Costs
Product Costs
Nonmanufacturing Costs
Indirect Costs
Indirect Costs
Overhead Costs:
Product or Period Costs
many managers believed that direct labor-hours, the total volume of units produced, and
overhead costs were highly correlated. (Three variables, such as direct labor-hours, the
total volume of units produced, and overhead costs, are highly correlated if they tend to
move together.) Given that most companies at the time were producing a very limited
variety of products that required similar resources to produce, allocation bases such as
direct labor-hours, or even machine-hours, worked fine because, in fact, there was probably little difference in the overhead costs attributable to different products.
Then conditions began to change. As a percentage of total cost, direct labor began
declining and overhead began increasing. Many tasks previously done by direct laborers
were being performed by automated equipment—a component of overhead. Companies
began creating new products and services at an ever-accelerating rate that differed in volume, batch size, and complexity. Managing and sustaining this product diversity required
investing in many more overhead resources, such as production schedulers and product
design engineers, that had no obvious connection to direct labor-hours or machine-hours.
In this new environment, continuing to rely exclusively on a limited number of overhead
cost pools and traditional allocation bases posed the risk that reported unit product costs
would be distorted and, therefore, misleading when used for decision-making purposes.
Direct Costs
Product Costs
290
Chapter 7
Activity-based costing, thanks to advances in technology that make more complex
cost systems feasible, provides an alternative to the traditional plantwide and departmental approaches to defining cost pools and selecting allocation bases. The activity-based
approach has appeal in today’s business environment because it uses more cost pools and
unique measures of activity to better understand the costs of managing and sustaining
product diversity.
In activity-based costing, an activity is any event that causes the consumption of
overhead resources. An activity cost pool is a “bucket” in which costs are accumulated
that relate to a single activity measure in the ABC system. An activity measure is an
allocation base in an activity-based costing system. The term cost driver is also used to
refer to an activity measure because the activity measure should “drive” the cost being
allocated. The two most common types of activity measures are transaction drivers and
duration drivers. Transaction drivers are simple counts of the number of times an activity occurs, such as the number of bills sent out to customers. Duration drivers measure
the amount of time required to perform an activity, such as the time spent preparing
individual bills for customers. In general, duration drivers are more accurate measures of
resource consumption than transaction drivers, but they take more effort to record. For
that reason, transaction drivers are often used in practice.
IN BUSINESS
A CRITICAL PERSPECTIVE OF ABC
Marconi is a Portuguese telecommunications company that encountered problems with its ABC
system. The company’s production managers felt that 23% of the costs included in the system were
common costs that should not be allocated to products and that allocating these costs to products
was not only inaccurate, but also irrelevant to their operational cost reduction efforts. Furthermore,
Marconi’s front-line workers resisted the ABC system because they felt it might be used to weaken
their autonomy and to justify downsizing, outsourcing, and work intensification. They believed that
ABC created a “turkeys queuing for Christmas syndrome” because they were expected to volunteer
information to help create a cost system that could eventually lead to their demise. These two complications created a third problem—the data necessary to build the ABC cost model was provided
by disgruntled and distrustful employees. Consequently, the accuracy of the data was questionable
at best. In short, Marconi’s experiences illustrate some of the challenges that complicate real-world
ABC implementations.
Source: Maria Major and Trevor Hopper, “Managers Divided: Implementing ABC in a Portuguese Telecommunications Company,” Management Accounting Research, June 2005, pp. 205–229.
Traditional cost systems rely exclusively on allocation bases that are driven by the volume of production. On the other hand, activity-based costing defines five levels of activity—
unit-level, batch-level, product-level, customer-level, and organization-sustaining—that
largely do not relate to the volume of units produced. The costs and corresponding activity
measures for unit-level activities do relate to the volume of units produced; however, the
remaining categories do not. These levels are described as follows:2
1. Unit-level activities are performed each time a unit is produced. The costs of unitlevel activities should be proportional to the number of units produced. For example,
providing power to run processing equipment would be a unit-level activity because
power tends to be consumed in proportion to the number of units produced.
2. Batch-level activities are performed each time a batch is handled or processed,
regardless of how many units are in the batch. For example, tasks such as placing
2
Robin Cooper, “Cost Classification in Unit-Based and Activity-Based Manufacturing Cost Systems,”
Journal of Cost Management, Fall 1990, pp. 4–14.
Activity-Based Costing: A Tool to Aid Decision Making
291
purchase orders, setting up equipment, and arranging for shipments to customers
are batch-level activities. They are incurred once for each batch (or customer order).
Costs at the batch level depend on the number of batches processed rather than on
the number of units produced, the number of units sold, or other measures of volume. For example, the cost of setting up a machine for batch processing is the same
regardless of whether the batch contains one or thousands of items.
3. Product-level activities relate to specific products and typically must be carried out
regardless of how many batches are run or units of product are produced or sold. For
example, activities such as designing a product, advertising a product, and maintaining a product manager and staff are all product-level activities.
4. Customer-level activities relate to specific customers and include activities such as
sales calls, catalog mailings, and general technical support that are not tied to any
specific product.
5. Organization-sustaining activities are carried out regardless of which customers
are served, which products are produced, how many batches are run, or how many
units are made. This category includes activities such as heating the factory, cleaning executive offices, providing a computer network, arranging for loans, preparing
annual reports to shareholders, and so on.
Many companies throughout the world continue to base overhead allocations on
direct labor-hours or machine-hours. In situations where overhead costs and direct laborhours are highly correlated or in situations where the goal of the overhead allocation
process is to prepare external financial reports, this practice makes sense. However, if
plantwide overhead costs do not move in tandem with plantwide direct labor-hours or
machine-hours, product costs will be distorted—with the potential of distorting decisions
made within the company.
DINING IN THE CANYON
Western River Expeditions (www.westernriver.com) runs river rafting trips on the Colorado, Green,
and Salmon rivers. One of its most popular trips is a six-day trip down the Grand Canyon, which
features famous rapids such as Crystal and Lava Falls as well as the awesome scenery accessible
only from the bottom of the Grand Canyon. The company runs trips of one or two rafts, each of
which carries two guides and up to 18 guests. The company provides all meals on the trip, which
are prepared by the guides.
In terms of the hierarchy of activities, a guest can be considered as a unit and a raft as a batch.
In that context, the wages paid to the guides are a batch-level cost because each raft requires two
guides regardless of the number of guests in the raft. Each guest is given a mug to use during the
trip and to take home at the end of the trip as a souvenir. The cost of the mug is a unit-level cost
because the number of mugs given away is strictly proportional to the number of guests on a trip.
What about the costs of food served to guests and guides—is this a unit-level cost, a batchlevel cost, a product-level cost, or an organization-sustaining cost? At first glance, it might be
thought that food costs are a unit-level cost—the greater the number of guests, the higher the food
costs. However, that is not quite correct. Standard menus have been created for each day of the
trip. For example, the first night’s menu might consist of shrimp cocktail, steak, cornbread, salad,
and cheesecake. The day before a trip begins, all of the food needed for the trip is taken from the
central warehouse and packed in modular containers. It isn’t practical to finely adjust the amount of
food for the actual number of guests planned to be on a trip—most of the food comes prepackaged
in large lots. For example, the shrimp cocktail menu may call for two large bags of frozen shrimp
per raft and that many bags will be packed regardless of how many guests are expected on the
raft. Consequently, the costs of food are not a unit-level cost that varies with the number of guests
actually on a trip. Instead, the costs of food are a batch-level cost.
Source: Conversations with Western River Expeditions personnel.
IN BUSINESS
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Chapter 7
Designing an Activity-Based Costing (ABC) System
There are three essential characteristics of a successful activity-based costing implementation. First, top managers must strongly support the ABC implementation because their
leadership is instrumental in properly motivating all employees to embrace the need to
change. Second, top managers should ensure that ABC data is linked to how people are
evaluated and rewarded. If employees continue to be evaluated and rewarded using traditional (non-ABC) cost data, they will quickly get the message that ABC is not important and they will abandon it. Third, a cross-functional team should be created to design
and implement the ABC system. The team should include representatives from each area
that will use ABC data, such as the marketing, production, engineering, and accounting
departments. These cross-functional employees possess intimate knowledge of many parts
of an organization’s operations that is necessary for designing an effective ABC system.
Furthermore, tapping the knowledge of cross-functional managers lessens their resistance to ABC because they feel included in the implementation process. Time after time,
when accountants have attempted to implement an ABC system on their own without
top-management support and cross-functional involvement, the results have been ignored.
IN BUSINESS
IMPLEMENTING ACTIVITY-BASED COSTING IN CHINA
Xu Ji Electric Company is publicly traded on China’s Shen Zhen Stock Exchange. From 2001–2003,
it successfully implemented an activity-based costing (ABC) system because top-level managers
continuously supported the new system—particularly during a challenging phase when the ABC
software encountered problems. The ABC adoption was also aided by Xu Ji’s decision to drive the
implementation using a top-down approach, which is aligned with the company’s cultural norm of
deferring to and supporting the hierarchical chain of command.
Xu Ji’s experience is similar to Western ABC implementations that have consistently recognized the necessity of top-level management support. However, contrary to Xu Ji’s experience,
many Western managers do not readily support the top-down implementation of new management
innovations in their organizations. They prefer to be involved in the decision-making processes that
introduce change into their organizations.
Source: Lana Y.J. Liu and Fei Pan, “The Implementation of Activity-Based Costing in China: An Innovation Action
Research Approach,” The British Accounting Review 39, 2007, pp. 249–264.
MANAGERIAL
ACCOUNTING IN ACTION
THE ISSUE
Classic Brass, Inc., makes two main product lines for luxury yachts—standard stanchions
and custom compass housings. The president of the company, John Towers, recently
attended a management conference at which activity-based costing was discussed. Following the conference, he called a meeting of the company’s top managers to discuss
what he had learned. Attending the meeting were production manager Susan Richter, the
marketing manager Tom Olafson, and the accounting manager Mary Goodman. He began
the conference by distributing the company’s income statement that Mary Goodman had
prepared a few hours earlier (see Exhibit 7–2):
John: Well, it’s official. Our company has sunk into the red for the first time in its
history—a loss of $1,250.
Tom: I don’t know what else we can do! Given our successful efforts to grow sales of
the custom compass housings, I was expecting to see a boost to our bottom line, not
a net loss. Granted, we have been losing even more bids than usual for standard stanchions because of our recent price increase, but . . .
John: Do you think our prices for standard stanchions are too high?
Activity-Based Costing: A Tool to Aid Decision Making
EXHIBIT 7–2
Classic Brass Income Statement
Classic Brass
Income Statement
Year Ended December 31, 2014
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold:
Direct materials . . . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead* . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Shipping expenses . . . . . . . . . . . . . . . . . . .
General administrative expenses . . . . . . . . .
Marketing expenses . . . . . . . . . . . . . . . . . .
Net operating loss . . . . . . . . . . . . . . . . . . . . . .
$3,200,000
$ 975,000
351,250
1,000,000
293
2,326,250
873,750
65,000
510,000
300,000
$
875,000
(1,250)
*The company’s traditional cost system allocates manufacturing overhead
to products using a plantwide overhead rate and machine-hours as the
allocation base. Inventory levels did not change during the year.
Tom: No, I don’t think our prices are too high. I think our competitors’ prices are too
low. In fact, I’ll bet they are pricing below their cost.
Susan: Why would our competitors price below their cost?
Tom: They are out to grab market share.
Susan: What good is more market share if they are losing money on every unit sold?
John: I think Susan has a point. Mary, what is your take on this?
Mary: If our competitors are pricing standard stanchions below cost, shouldn’t they be
losing money rather than us? If our company is the one using accurate information to
make informed decisions while our competitors are supposedly clueless, then why is
our “bottom line” taking a beating? Unfortunately, I think we may be the ones relying on distorted cost data, not our competitors.
John: Based on what I heard at the conference that I just attended, I am inclined to
agree. One of the presentations at the conference dealt with activity-based costing.
As the speaker began describing the usual insights revealed by activity-based costing
systems, I was sitting in the audience getting an ill feeling in my stomach.
Mary: Honestly John, I have been claiming for years that our existing cost system is
okay for external reporting, but it is dangerous to use it for internal decision making.
It sounds like you are on board now, right?
John: Yes.
Mary: Well then, how about if all of you commit the time and energy to help me build a
fairly simple activity-based costing system that may shed some light on the problems
we are facing?
John: Let’s do it. I want each of you to appoint one of your top people to a special
“ABC team” to investigate how we cost products.
Like most other ABC implementations, the ABC team decided that its new ABC system would supplement, rather than replace, the existing cost accounting system, which
would continue to be used for external financial reports. The new ABC system would be
used to prepare special reports for management decisions such as bidding on new business.
The accounting manager drew the chart appearing in Exhibit 7–3 to explain the general structure of the ABC model to her team members. Cost objects such as products generate activities. For example, a customer order for a custom compass housing requires the
activity of preparing a production order. Such an activity consumes resources. A production order uses a sheet of paper and takes time to fill out. And consumption of resources
causes costs. The greater the number of sheets used to fill out production orders and
294
Chapter 7
EXHIBIT 7–3
The Activity-Based Costing
Model
Cost Objects
(e.g., products and customers)
Activities
Consumption of Resources
Cost
the greater the amount of time devoted to filling out such orders, the greater the cost.
Activity-based costing attempts to trace through these relationships to identify how products and customers affect costs.
As in most other companies, the ABC team at Classic Brass felt that the company’s traditional cost accounting system adequately measured the direct materials and
direct labor costs of products because these costs are directly traced to products. Therefore, the ABC study would be concerned solely with the other costs of the company—
manufacturing overhead and selling and administrative costs.
The team felt it was important to carefully plan how it would go about implementing
the new ABC system at Classic Brass. Accordingly, it broke down the implementation
process into five steps:
Steps for Implementing Activity-Based Costing:
1.
2.
3.
4.
5.
Define activities, activity cost pools, and activity measures.
Assign overhead costs to activity cost pools.
Calculate activity rates.
Assign overhead costs to cost objects using the activity rates and activity measures.
Prepare management reports.
Step 1: Define Activities, Activity Cost Pools, and
Activity Measures
The first major step in implementing an ABC system is to identify the activities that will
form the foundation for the system. This can be difficult and time-consuming and involves
a great deal of judgment. A common procedure is for the individuals on the ABC implementation team to interview people who work in overhead departments and ask them to
describe their major activities. Ordinarily, this results in a very long list of activities.
The length of such lists of activities poses a problem. On the one hand, the greater the
number of activities tracked in the ABC system, the more accurate the costs are likely to
be. On the other hand, a complex system involving large numbers of activities is costly
to design, implement, maintain, and use. Consequently, the original lengthy list of activities is usually reduced to a handful by combining similar activities. For example, several actions may be involved in handling and moving raw materials—from receiving raw
materials on the loading dock to sorting them into the appropriate bins in the storeroom.
All of these activities might be combined into a single activity called material handling.
When combining activities in an ABC system, activities should be grouped together
at the appropriate level. Batch-level activities should not be combined with unit-level
Activity-Based Costing: A Tool to Aid Decision Making
295
activities or product-level activities with batch-level activities and so on. In general, it is
best to combine only those activities that are highly correlated with each other within a
level. For example, the number of customer orders received is likely to be highly correlated
with the number of completed customer orders shipped, so these two batch-level activities
(receiving and shipping orders) can usually be combined with little loss of accuracy.
At Classic Brass, the ABC team, in consultation with top managers, selected the following activity cost pools and activity measures:
Activity Cost Pools at Classic Brass
Activity Cost Pool
Customer orders . . . . . . . .
Product design . . . . . . . . .
Order size . . . . . . . . . . . . .
Customer relations . . . . . .
Other . . . . . . . . . . . . . . . . .
Activity Measure
Number of customer orders
Number of product designs
Machine-hours
Number of active customers
Not applicable
The Customer Orders cost pool will be assigned all costs of resources that are consumed by taking and processing customer orders, including costs of processing paperwork and any costs involved in setting up machines for specific orders. The activity
measure for this cost pool is the number of customer orders received. This is a batch-level
activity because each order generates work that occurs regardless of whether the order is
for one unit or 1,000 units.
The Product Design cost pool will be assigned all costs of resources consumed by
designing products. The activity measure for this cost pool is the number of products
designed. This is a product-level activity because the amount of design work on a new product does not depend on the number of units ultimately ordered or batches ultimately run.
The Order Size cost pool will be assigned all costs of resources consumed as a consequence of the number of units produced, including the costs of miscellaneous factory
supplies, power to run machines, and some equipment depreciation. This is a unit-level
activity because each unit requires some of these resources. The activity measure for this
cost pool is machine-hours.
The Customer Relations cost pool will be assigned all costs associated with maintaining relations with customers, including the costs of sales calls and the costs of entertaining customers. The activity measure for this cost pool is the number of customers the
company has on its active customer list. The Customer Relations cost pool represents a
customer-level activity.
The Other cost pool will be assigned all overhead costs that are not associated with
customer orders, product design, the size of the orders, or customer relations. These costs
mainly consist of organization-sustaining costs and the costs of unused, idle capacity.
These costs will not be assigned to products because they represent resources that are not
consumed by products.
It is unlikely that any other company would use exactly the same activity cost pools
and activity measures that were selected by Classic Brass. Because of the amount of
judgment involved, the number and definitions of the activity cost pools and activity measures used by companies vary considerably.
The Mechanics of Activity-Based Costing
Step 2: Assign Overhead Costs to Activity Cost Pools
Exhibit 7–4 shows the annual overhead costs (both manufacturing and nonmanufacturing)
that Classic Brass intends to assign to its activity cost pools. Notice the data in the exhibit are
organized by department (e.g., Production, General Administrative, and Marketing). This is
because the data have been extracted from the company’s general ledger. General ledgers
LO7–2
Assign costs to cost pools
using a first-stage allocation.
296
EXHIBIT 7–4
Annual Overhead Costs
(Both Manufacturing and
Nonmanufacturing) at Classic
Brass
Chapter 7
Production Department:
Indirect factory wages . . . . . . . . . . . . . . . . . .
Factory equipment depreciation . . . . . . . . . .
Factory utilities . . . . . . . . . . . . . . . . . . . . . . . .
Factory building lease . . . . . . . . . . . . . . . . . .
General Administrative Department:
Administrative wages and salaries . . . . . . . .
Office equipment depreciation . . . . . . . . . . .
Administrative building lease . . . . . . . . . . . . .
Marketing Department:
Marketing wages and salaries . . . . . . . . . . . .
Selling expenses . . . . . . . . . . . . . . . . . . . . . .
Total overhead cost . . . . . . . . . . . . . . . . . . . . . .
$500,000
300,000
120,000
80,000
$1,000,000
400,000
50,000
60,000
510,000
250,000
50,000
300,000
$1,810,000
usually classify costs within the departments where the costs are incurred. For example,
salaries, supplies, rent, and so forth incurred in the marketing department are charged to that
department. The functional orientation of the general ledger mirrors the presentation of costs
in the absorption income statement in Exhibit 7–2. In fact, you’ll notice the total costs for
the Production Department in Exhibit 7–4 ($1,000,000) equal the total manufacturing overhead costs from the income statement in Exhibit 7–2. Similarly, the total costs for the General Administrative and Marketing Departments in Exhibit 7–4 ($510,000 and $300,000)
equal the marketing and general and administrative expenses shown in Exhibit 7–2.
Three costs included in the income statement in Exhibit 7–2—direct materials,
direct labor, and shipping—are excluded from the costs shown in Exhibit 7–4. The
ABC team purposely excluded these costs from Exhibit 7–4 because the existing cost
system can accurately trace direct materials, direct labor, and shipping costs to products. There is no need to incorporate these direct costs in the activity-based allocations
of indirect costs.
Classic Brass’s activity-based costing system will divide the nine types of overhead
costs in Exhibit 7–4 among its activity cost pools via an allocation process called firststage allocation. The first-stage allocation in an ABC system is the process of assigning
functionally organized overhead costs derived from a company’s general ledger to the
activity cost pools.
First-stage allocations are usually based on the results of interviews with employees
who have first-hand knowledge of the activities. For example, Classic Brass needs to
allocate $500,000 of indirect factory wages to its five activity cost pools. These allocations will be more accurate if the employees who are classified as indirect factory
workers (e.g., supervisors, engineers, and quality inspectors) are asked to estimate what
percentage of their time is spent dealing with customer orders, with product design, with
processing units of product (i.e., order size), and with customer relations. These interviews are conducted with considerable care. Those who are interviewed must thoroughly
understand what the activities encompass and what is expected of them in the interview.
In addition, departmental managers are typically interviewed to determine how the nonpersonnel costs should be distributed across the activity cost pools. For example, the
Classic Brass production manager would be interviewed to determine how the $300,000
of factory equipment depreciation (shown in Exhibit 7–4) should be allocated to the
activity cost pools. The key question that the production manager would need to answer
is “What percentage of the available machine capacity is consumed by each activity such
as the number of customer orders or the number of units processed (i.e., size of orders)?”
The results of the interviews at Classic Brass are displayed in Exhibit 7–5. For example, factory equipment depreciation is distributed 20% to Customer Orders, 60% to Order
Size, and 20% to the Other cost pool. The resource in this instance is machine time.
According to the estimates made by the production manager, 60% of the total available
Activity-Based Costing: A Tool to Aid Decision Making
EXHIBIT 7–5
Results of Interviews: Distribution
of Resource Consumption
across Activity Cost Pools
EXHIBIT 7–6
First-Stage Allocations to Activity
Cost Pools
Exhibit 7–5 shows that Customer Orders consume 25% of the
resources represented by the $500,000 of indirected factory wages.
25% 3 $500,000 5 $125,000
Other entries in the table are computed in a similar fashion.
297
298
IN BUSINESS
Chapter 7
AN ABC APPLICATION IN THE CONSTRUCTION INDUSTRY
Researchers from the United States and the Republic of Korea studied how a Korean manufacturer
assigned the indirect costs of supplying reinforced steel bars (also called rebar) to various construction projects. The company’s traditional cost system assigned all indirect costs to projects using
rebar tonnage as the allocation base. Its ABC system had 10 activities that assigned indirect costs
to projects using activity measures such as number of orders, number of sheets, number of distributing runs, number of production runs, and number of inspections.
The traditional and ABC systems assigned the following overhead costs to three construction
projects called Commercial, High-Rise Condo, and Heavy Civil:
Commercial
High-Rise
Condo
Heavy
Civil
Traditional cost system allocations . . . . . . . .
ABC allocations . . . . . . . . . . . . . . . . . . . . . . .
$ 64,587
90,466
$ 50,310
61,986
$91,102
53,548
Difference . . . . . . . . . . . . . . . . . . . . . . . . . . .
$(25,879)
$(11,676)
$37,554
Notice that the traditional cost system was undercosting the Commercial and High-Rise Condo projects relative to the ABC system. It was also overcosting the Heavy Civil project by $37,554 when
compared to the ABC system.
Source: Yong-Woo Kim, Seungheon Han, “Sungwon Shin, and Kunhee Choi, “A Case Study of Activity-Based
Costing in Allocation Rebar Fabrication Costs to Projects,” Construction Management and Economics, May
2010, pp. 449–461.
machine time was used to actually process units to fill orders. This percentage is entered
in the Order Size column. Each customer order requires setting up, which also requires
machine time. This activity consumes 20% of the total available machine time and is
entered under the Customer Orders column. The remaining 20% of available machine
time represents idle time and is entered under the Other column.
Exhibit 7–5 and many of the other exhibits in this chapter are presented in the form of
Excel spreadsheets. All of the calculations required in activity-based costing can be done
by hand. Nevertheless, setting up an activity-based costing system on a spreadsheet or
using special ABC software can save a lot of work—particularly in situations involving
many activity cost pools and in organizations that periodically update their ABC systems.
We will not go into the details of how all of the percentages in Exhibit 7–5 were
determined. However, note that 100% of the factory building lease has been assigned
to the Other cost pool. Classic Brass has a single production facility. It has no plans to
expand or to sublease any excess space. The cost of this production facility is treated as
an organization-sustaining cost because there is no way to avoid even a portion of this
cost if a particular product or customer were to be dropped. (Remember that organizationsustaining costs are assigned to the Other cost pool and are not allocated to products.) In
contrast, some companies have separate facilities for manufacturing specific products.
The costs of these separate facilities could be directly traced to the specific products.
Once the percentage distributions in Exhibit 7–5 have been established, it is easy to
allocate costs to the activity cost pools. The results of this first-stage allocation are displayed in Exhibit 7–6. Each cost is allocated across the activity cost pools by multiplying
it by the percentages in Exhibit 7–5. For example, the indirect factory wages of $500,000
are multiplied by the 25% entry under Customer Orders in Exhibit 7–5 to arrive at the
$125,000 entry under Customer Orders in Exhibit 7–6. Similarly, the indirect factory
wages of $500,000 are multiplied by the 40% entry under Product Design in Exhibit 7–5
to arrive at the $200,000 entry under Product Design in Exhibit 7–6. All of the entries in
Exhibit 7–6 are computed in this way.
Activity-Based Costing: A Tool to Aid Decision Making
299
Now that the first-stage allocations to the activity cost pools have been completed,
the next step is to compute the activity rates.
Step 3: Calculate Activity Rates
The activity rates that will be used for assigning overhead costs to products and customers
are computed in Exhibit 7–7. The ABC team determined the total activity for each cost pool
that would be required to produce the company’s present product mix and to serve its present
customers. These numbers are listed in Exhibit 7–7. For example, the ABC team found that
400 new product designs are required each year to serve the company’s present customers.
The activity rates are computed by dividing the total cost for each activity by its total activity. For example, the $320,000 total annual cost for the Customer Orders cost pool (which
was computed in Exhibit 7–6) is divided by the total of 1,000 customer orders per year to
arrive at the activity rate of $320 per customer order. Similarly, the $252,000 total cost for the
Product Design cost pool is divided by the total number of designs (i.e., 400 product designs)
to determine the activity rate of $630 per design. Note that an activity rate is not computed
for the Other category of costs. This is because the Other cost pool consists of organizationsustaining costs and costs of idle capacity that are not allocated to products and customers.
The rates in Exhibit 7–7 indicate that on average a customer order consumes resources
that cost $320; a product design consumes resources that cost $630; a unit of product consumes resources that cost $19 per machine-hour; and maintaining relations with a customer consumes resources that cost $1,470. Note that these are average figures. Some
members of the ABC design team at Classic Brass argued that it would be unfair to charge
all new products the same $630 product design cost regardless of how much design time
they actually require. After discussing the pros and cons, the team concluded that it would
not be worth the effort at the present time to keep track of actual design time spent on each
new product. They felt that the benefits of increased accuracy would not be great enough
to justify the higher cost of implementing and maintaining the more detailed costing system. Similarly, some team members were uncomfortable assigning the same $1,470 cost
to each customer. Some customers are undemanding—ordering standard products well in
advance of their needs. Others are very demanding and consume large amounts of marketing and administrative staff time. These are generally customers who order customized
products, who tend to order at the last minute, and who change their minds. While everyone agreed with this observation, the data that would be required to measure individual
customers’ demands on resources were not currently available. Rather than delay implementation of the ABC system, the team decided to defer such refinements to a later date.
Before proceeding further, it would be helpful to get a better idea of the overall process
of assigning costs to products and other cost objects in an ABC system. Exhibit 7–8 provides
LO7–3
Compute activity rates for cost
pools.
EXHIBIT 7–7
Computation of Activity Rates
300
Chapter 7
EXHIBIT 7–8
The Activity-Based Costing Model at Classic Brass
Direct
Materials
Direct
Labor
Overhead Costs
(Manufacturing and Nonmanufacturing)
$1,810,000
Shipping
Costs
First-Stage Allocations
Traced
Traced
Traced
Customer
Orders
$320,000
Product
Design
$252,000
Order
Size
$380,000
Customer
Relations
$367,500
Other
$490,500
Second-Stage Allocations
$320 per
order
$630 per
design
Cost Objects:
Products, Customer Orders, Customers
$19 per
MH
$1,470 per
customer
Unallocated
a visual perspective of the ABC system at Classic Brass. We recommend that you carefully
go over this exhibit. In particular, note that the Other category, which contains organizationsustaining costs and costs of idle capacity, is not allocated to products or customers.
Step 4: Assign Overhead Costs to Cost Objects
LO7–4
Assign costs to a cost
object using a second-stage
allocation.
The fourth step in the implementation of activity-based costing is called second-stage
allocation. In the second-stage allocation, activity rates are used to apply overhead costs
to products and customers. First, we will illustrate how to assign costs to products followed by an example of how to assign costs to customers.
The data needed by the ABC team to assign overhead costs to Classic Brass’s two
products—standard stanchions and custom compass housings—are as follows:
Standard Stanchions
1.
2.
3.
This product line does not require any new design resources.
30,000 units were ordered during the year, comprising 600 separate orders.
Each stanchion requires 35 minutes of machine time for a total of 17,500
machine-hours.
Custom Compass Housings
1.
2.
3.
4.
This is a custom product that requires new design resources.
There were 400 orders for custom compass housings. Orders for this product
are placed separately from orders for standard stanchions.
There were 400 custom designs prepared. One custom design was prepared
for each order.
Because some orders were for more than one unit, a total of 1,250 custom
compass housings were produced during the year. A custom compass housing
requires an average of 2 machine-hours for a total of 2,500 machine-hours.
Notice, 600 customer orders were placed for standard stanchions and 400 customer
orders were placed for custom compass housings, for a total of 1,000 customer orders.
All 400 product designs related to custom compass housings; none related to standard
stanchions. Producing 30,000 standard stanchions required 17,500 machine-hours and
Activity-Based Costing: A Tool to Aid Decision Making
HOW MUCH DOES IT COST TO HANDLE A PIECE OF LUGGAGE?
It costs an airline about $15 to carry a piece of checked luggage from one destination another. The
activity “transporting luggage” consists of numerous sub-activities such as tagging bags, sorting
them, placing them on carts, transporting bags planeside, loading them into the airplane, and delivering them to carousels and connecting flights.
A variety of employees invest a portion of their labor hours “transporting luggage” including
ground personnel, check-in agents, service clerks, baggage service managers, and maintenance
workers. In total, labor costs comprise $9 per bag. Airlines also spend millions of dollars on baggage equipment, sorting systems, carts, tractors, and conveyors, as well as rental costs related to
bag rooms, carousels, and offices. They also pay to deliver misplaced bags to customers’ homes
and to compensate customers for lost bags that are never found. These expenses add up to about
$4 per bag. The final expense related to transporting luggage is fuel costs, which average about
$2 per bag.
Many major airlines now charge fees for checked bags. United Airlines expects to collect $275
million annually for its first and second bag fees.
Source: Scott McCartney, “What It Costs an Airline to Fly Your Luggage,” The Wall Street Journal, November 25,
2008, p. D1 and D8.
producing 1,250 custom compass housings required 2,500 machine-hours, for a total of
20,000 machine-hours.
Exhibit 7–9 illustrates how overhead costs are assigned to the standard stanchions
and custom compass housings. For example, the exhibit shows that $192,000 of overhead costs are assigned from the Customer Orders activity cost pool to the standard
stanchions ($320 per order 3 600 orders). Similarly, $128,000 of overhead costs are
assigned from the Customer Orders activity cost pool to the custom compass housings
EXHIBIT 7–9
Assigning Overhead Costs to Products
301
IN BUSINESS
302
Chapter 7
($320 per order 3 400 orders). The Customer Orders cost pool contained a total of
$320,000 (see Exhibit 7–6 or 7–7) and this total amount has been assigned to the two
products ($192,000 1 $128,000 5 $320,000).
Exhibit 7–9 shows that a total of $952,000 of overhead costs is assigned to Classic Brass’s two product lines—$524,500 to standard stanchions and $427,500 to custom compass housings. This amount is less than the $1,810,000 of overhead costs
included in the ABC system. Why? The total amount of overhead assigned to products does not match the total amount of overhead cost in the ABC system because
the ABC team purposely did not assign the $367,500 of Customer Relations and
$490,500 of Other costs to products. The Customer Relations activity is a customerlevel activity and the Other activity is an organization-sustaining activity—neither
activity is caused by products. As shown below, when the Customer Relations and
Other activity costs are added to the $952,000 of overhead costs assigned to products,
the total is $1,810,000.
Overhead Costs Assigned to Products
Customer orders . . . . . . . . . . . . . . . . . . . .
Product design . . . . . . . . . . . . . . . . . . . . .
Order size . . . . . . . . . . . . . . . . . . . . . . . . . .
Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . .
Overhead Costs not Assigned to Products
Customer relations . . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total overhead cost . . . . . . . . . . . . . . . . . . . .
Standard
Stanchions
Custom
Compass
Housings
Total
$192,000
0
332,500
$524,500
$128,000
252,000
47,500
$427,500
$ 320,000
252,000
380,000
952,000
367,500
490,500
858,000
$1,810,000
Next, we describe another example of second-stage allocation—assigning activity
costs to customers. The data needed by Classic Brass to assign overhead costs to one of
its customers—Windward Yachts—are as follows:
Windward Yachts
1.
The company placed a total of three orders.
a. Two orders were for 150 standard stanchions per order.
b. One order was for a single custom compass housing unit.
2. A total of 177 machine-hours were used to fulfill the three customer orders.
a. The 300 standard stanchions required 175 machine-hours.
b. The custom compass housing required 2 machine-hours.
3. Windward Yachts is one of 250 customers served by Classic Brass.
Exhibit 7–10 illustrates how the ABC system assigns overhead costs to this customer. As shown in Exhibit 7–10, the ABC team calculated that $6,423 of overhead
costs should be assigned to Windward Yachts. The exhibit shows that Windward Yachts
is assigned $960 ($320 per order 3 3 orders) of overhead costs from the Customer
Orders activity cost pool; $630 ($630 per design 3 1 design) from the Product Design
cost pool; $3,363 ($19 per machine-hour 3 177 machine-hours) from the Order Size
cost pool; and $1,470 ($1,470 per customer 3 1 customer) from the Customer Relations cost pool.
Activity-Based Costing: A Tool to Aid Decision Making
303
EXHIBIT 7–10
Assigning Overhead Costs to Customers
With second-stage allocations complete, the ABC design team was ready to turn its attention to creating reports that would help explain the company’s first ever net operating loss.
Step 5: Prepare Management Reports
The most common management reports prepared with ABC data are product and customer profitability reports. These reports help companies channel their resources to their
most profitable growth opportunities while at the same time highlighting products and
customers that drain profits. We begin by illustrating a product profitability report followed by a customer profitability report.
The Classic Brass ABC team realized that the profit from a product, also called the
product margin, is a function of the product’s sales and the direct and indirect costs that
the product causes. The ABC cost allocations shown in Exhibit 7–9 only summarize each
product’s indirect (i.e., overhead) costs. Therefore, to compute a product’s profit (i.e.,
product margin), the design team needed to gather each product’s sales and direct costs
in addition to the overhead costs previously computed. The pertinent sales and direct cost
data for each product are shown below. Notice the numbers in the total column agree with
the income statement in Exhibit 7–2.
Sales . . . . . . . . . . . . . . . .
Direct costs:
Direct materials . . . . . .
Direct labor . . . . . . . . .
Shipping . . . . . . . . . . . .
Standard
Stanchions
Custom Compass
Housings
Total
$2,660,000
$540,000
$3,200,000
$905,500
$263,750
$60,000
$69,500
$87,500
$5,000
$975,000
$351,250
$65,000
Having gathered the above data, the design team created the product profitability
report shown in Exhibit 7–11. The report revealed that standard stanchions are profitable,
with a positive product margin of $906,250, whereas the custom compass housings are
unprofitable, with a negative product margin of $49,500. Keep in mind that the product
profitability report purposely does not include the costs in the Customer Relations and
Other activity cost pools. These costs, which total $858,000, were excluded from the
LO7–5
Use activity-based costing to
compute product and customer
margins.
304
Chapter 7
EXHIBIT 7–11
Product Margins—Activity-Based
Costing
report because they are not caused by the products. Customer Relations costs are caused
by customers, not products. The Other costs are organization-sustaining costs and unused
capacity costs that are not caused by any particular product.
The product margins can be reconciled with the company’s net operating loss as
follows:
Sales (See Exhibit 7–11) . . . . . . . . . . . . . . .
Total costs (See Exhibit 7–11) . . . . . . . . . . .
Product margins (See Exhibit 7–11) . . . . . .
Overhead costs not assigned to products:
Customer relations . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net operating loss . . . . . . . . . . . . . . . . . . . .
Standard
Stanchions
Custom
Compass
Housings
Total
$2,660,000
1,753,750
$ 906,250
$540,000
589,500
$ (49,500)
$3,200,000
2,343,250
856,750
367,500
490,500
858,000
$
(1,250)
Next, the design team created a customer profitability report for Windward Yachts.
Similar to the product profitability report, the design team needed to gather data concerning sales to Windward Yachts and the direct material, direct labor, and shipping costs
associated with those sales. Those data are presented below:
Windward Yachts
Sales . . . . . . . . . . . . . . . . . . . .
Direct costs:
Direct material costs . . . . . .
Direct labor costs . . . . . . . . .
Shipping costs . . . . . . . . . . .
$11,350
$2,123
$1,900
$205
Activity-Based Costing: A Tool to Aid Decision Making
305
IN BUSINESS
IS ACTIVITY-BASED COSTING STILL BEING USED?
Researchers surveyed 348 managers to determine which costing methods their companies use.
The table below shows the percentage of respondents whose companies use the various costing
methods to assign departmental costs to cost objects such as products.
Departments
Costing
Method
Activity-based
Standard1
Normal2
Actual3
Other
Not allocated
Research and
Development
Product and
Process
Design
Production
Sales and
Marketing
Distribution
Customer
Service
Shared
Services
13.0%
17.6%
4.6%
23.1%
1.9%
39.8%
14.7%
20.7%
8.6%
25.0%
0.9%
30.2%
18.3%
42.0%
9.9%
23.7%
0.0%
6.1%
17.3%
18.1%
7.9%
23.6%
0.8%
32.3%
17.2%
28.4%
6.0%
26.7%
0.9%
20.7%
21.8%
18.5%
8.1%
16.9%
1.6%
33.1%
23.0%
23.0%
5.6%
15.9%
2.4%
30.2%
1
Standard costing is used for the variance computations in Chapter 10.
Normal costing is used for the job-order costing computations in Chapter 3.
3
Actual costing is used to create the absorption and variable costing income statements in Chapter 6.
2
The results show that 18.3% of respondents use ABC to allocate production costs to cost
objects and 42% use standard costing for the same purpose. ABC is used by at least 13% of
respondents within all functional departments across the value chain. Many companies do not allocate nonproduction costs to cost objects.
Source: William O. Stratton, Denis Desroches, Raef Lawson, and Toby Hatch, “Activity-Based Costing: Is It Still
Relevant?” Management Accounting Quarterly, Spring 2009, pp. 31–40.
Using these data and the data from Exhibit 7–10, the design team created the customer profitability report shown in Exhibit 7–12. The report revealed that the customer
margin for Windward Yachts is $699. A similar report could be prepared for each of
EXHIBIT 7–12
Customer Margin—Activity-Based
Costing
306
Chapter 7
Classic Brass’s 250 customers, thereby enabling the company to cultivate relationships
with its most profitable customers, while taking steps to reduce the negative impact of
unprofitable customers.
Comparison of Traditional and ABC Product Costs
The ABC team used a two-step process to compare its traditional and ABC product costs.
First, the team reviewed the product margins reported by the traditional cost system.
Then, it contrasted the differences between the traditional and ABC product margins.
Product Margins Computed Using the Traditional Cost System
Classic Brass’s traditional cost system assigns only manufacturing costs to products—
this includes direct materials, direct labor, and manufacturing overhead. Selling and
administrative costs are not assigned to products. Exhibit 7–13 shows the product margins reported by Classic Brass’s traditional cost system. We will explain how these margins were calculated in three steps. First, the sales and direct materials and direct labor
cost data are the same numbers used by the ABC team to prepare Exhibit 7–11. In other
words, the traditional cost system and the ABC system treat these three pieces of revenue
and cost data identically.
Second, the traditional cost system uses a plantwide overhead rate to assign manufacturing overhead costs to products. The numerator for the plantwide overhead rate is
$1,000,000, which is the total amount of manufacturing overhead shown on the income
statement in Exhibit 7–2. The footnote in Exhibit 7–2 mentions that the traditional cost
system uses machine-hours to assign manufacturing overhead costs to products. The
Order Size activity in Exhibit 7–7 used 20,000 machine-hours as its level of activity.
These same 20,000 machine-hours would be used in the denominator of the plantwide
overhead rate, which is computed as follows:
Plantwide overhead rate 5
5
Total estimated manufacturing overhead
Total estimated machine-hours
$1,000,000
20,000 machine-hours
5 $50 per machine-hour
Because 17,500 machine-hours were worked on standard stanchions, this product line
is assigned $875,000 (17,500 machine-hours 3 $50 per machine-hour) of manufacturing
overhead cost. Similarly, the custom compass housings required 2,500 machine-hours, so
this product line is assigned $125,000 (2,500 machine-hours 3 $50 per machine-hour)
of manufacturing overhead cost. The sales of each product minus its cost of goods sold
equals the product margin of $615,750 for standard stanchions and $258,000 for custom
compass housings.
Notice, the net operating loss of $1,250 shown in Exhibit 7–13 agrees with the loss
reported in the income statement in Exhibit 7–2 and with the loss shown in the table
beneath Exhibit 7–11. The company’s total sales, total costs, and its resulting net operating loss are the same regardless of whether you are looking at the absorption income
statement in Exhibit 7–2, the ABC product profitability analysis depicted on page 304,
or the traditional product profitability analysis in Exhibit 7–13. Although the “total pie”
remains constant across the traditional and ABC systems, what differs is how the pie is
divided between the two product lines. The traditional product margin calculations suggest that standard stanchions are generating a product margin of $615,750 and the custom
compass housings a product margin of $258,000. However, these product margins differ
Activity-Based Costing: A Tool to Aid Decision Making
EXHIBIT 7–13
Product Margins—Traditional Costing System
from the ABC product margins reported in Exhibit 7–11. Indeed, the traditional cost system is sending misleading signals to Classic Brass’s managers about each product’s profitability. Let’s explain why.
The Differences between ABC and Traditional Product Costs
The changes in product margins caused by switching from the traditional cost system to
the activity-based costing system are shown below:
Product margins—traditional . . . . . . . . . . . .
Product margins—ABC . . . . . . . . . . . . . . . .
Change in reported product margins . . . . .
Standard
Stanchions
Custom Compass
Housings
$615,750
906,250
$290,500
$ 258,000
(49,500)
$(307,500)
The traditional cost system overcosts the standard stanchions and consequently reports
an artificially low product margin for this product. The switch to an activity-based view of
product profitability increases the product margin on standard stanchions by $290,500. In
contrast, the traditional cost system undercosts the custom compass housings and reports
an artificially high product margin for this product. The switch to activity-based costing
decreases the product margin on custom compass housings by $307,500.
The reasons for the change in reported product margins between the two costing
methods are revealed in Exhibit 7–14. The top portion of the exhibit shows each product’s direct and indirect cost assignments as reported by the traditional cost system in
Exhibit 7–13. For example, Exhibit 7–14 includes the following costs for standard stanchions: direct materials, $905,500; direct labor, $263,750; and manufacturing overhead,
$875,000. Each of these costs corresponds with those reported in Exhibit 7–13. Notice,
the selling and administrative costs of $875,000 are purposely not allocated to products
because these costs are considered to be period costs when using traditional costing.
Similarly, the bottom portion of Exhibit 7–14 summarizes the direct and indirect cost
assignments as reported by the activity-based costing system in Exhibit 7–11. The only
new information in Exhibit 7–14 is shown in the two columns of percentages. The first
column of percentages shows the percentage of each cost assigned to standard stanchions.
For example, the $905,500 of direct materials cost traced to standard stanchions is 92.9%
of the company’s total direct materials cost of $975,000. The second column of percentages does the same thing for custom compass housings.
307
308
Chapter 7
EXHIBIT 7–14
A Comparison of Traditional and
Activity-Based Cost Assignments
Standard
Stanchions
(a)
(a) 4 (c)
Amount
%
Traditional Cost System
Direct materials . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . .
$ 905,500
263,750
875,000
Total cost assigned to products . . . . . .
$2,044,250
92.9%
75.1%
87.5%
Custom Compass
Housings
(b)
(b) 4 (c)
Amount
%
$ 69,500
87,500
125,000
7.1%
24.9%
12.5%
(c)
Total
$ 975,000
351,250
1,000,000
2,326,250
$282,000
Selling and administrative . . . . . . . . . . .
875,000
Total cost . . . . . . . . . . . . . . . . . . . . . . . .
$3,201,250
Activity-Based Costing System
Direct costs:
Direct materials . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . .
Shipping . . . . . . . . . . . . . . . . . . . . . . .
Indirect costs:
Customer orders . . . . . . . . . . . . . . . .
Product design . . . . . . . . . . . . . . . . . .
Order size . . . . . . . . . . . . . . . . . . . . . .
Total cost assigned to products . . . . . .
$ 905,500
263,750
60,000
92.9%
75.1%
92.3%
$ 69,500
87,500
5,000
7.1%
24.9%
7.7%
$ 975,000
351,250
65,000
192,000
0
332,500
60.0%
0.0%
87.5%
128,000
252,000
47,500
40.0%
100.0%
12.5%
320,000
252,000
380,000
$1,753,750
$589,500
2,343,250
Costs not assigned to products:
Customer relations . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . .
367,500
490,